In 2007, Netflix launched an online streaming movie service to its subscribers. They would get to watch an ‘astonishing’ six hours of online content every month, or up to 18 hours if they were willing to pay more. But for most subscribers, this was merely a bonus feature because it required a minimum of 1 Mbps to stream films (below DVD quality) and 3 Mbps to stream them in their native resolution. Additionally, the DVD selection of 70,000 unique films dwarfed the online selection of 1000 films.
Netflix’s CEO Reed Hastings saw the bigger picture; he knew that this would be a long-term investment. After all, 2007 was the year where Netflix delivered their billionth DVD to its customers. The business wasn’t going to change overnight. Hastings said:
While mainstream consumer adoption of online movie watching will take a number of years due to content and technology hurdles, the time is right for Netflix to take the first step. Over the coming years we'll expand our selection of films, and we'll work to get to every Internet-connected screen, from cell phones to PCs to plasma screens.
The next year in 2008, Netflix upgraded its online streaming service. They expanded their online selection to over 6,000 films, allowed Mac users to stream for the first time, and removed monthly streaming limits. It came at no additional cost to their subscribers. These upgrades would erode Netflix’s profits — at the time, Netflix paid studios based on content utilisation which meant that the more subscribers stream, the more Netflix pays — but it fortified the company’s nascent streaming business against its competitors. It also accelerated Netflix’s change to become a streaming company.
By 2010, that change had arrived. In an earnings call, Hastings declared that they had fully transitioned to become a streaming company. They were no longer a DVD-by-mail company that happened to offer some streaming. By the end of the year, they were expecting to deliver more entertainment hours via streaming than via mail.
They also started to spend more money on acquiring content for streaming than for DVD. In August of that year, Netflix shelled out almost one billion dollars adding films from Paramount, LionsGate, and MGM to its online streaming service. As their Chief Content Officer (CCO) Ted Sarandos said, it would no longer be a streaming service that carried movies “you’ve never heard of”.
But they weren’t alone now. Competitors had emerged. Back in 2008, Hulu launched a free, ad-supported streaming service and, now in 2010, they added a paid-subscription option. Likewise, since 2006, Amazon Unbox had given customers the ability to download movies (though this was considered a failure). In 2011, the company launched its improved successor Amazon Instant Video. It would provide online streaming just like Netflix, but as a free add-on for its Prime members.
Hastings took note of this “vigorous competition” in a 2010 earnings call, but they were still the market leader with 20 million subscribers at the end of 2011. Amazon had five million Prime members and Hulu had one and a half million subscribers.
Initially, Netflix believed that its competitive advantage could come from maintaining their scale advantage. In a 2011 earnings call, Hastings said: “The profitability of a subscriber is based upon the barriers, competitive barriers on a relative scale. So in any market in which we have very strong scale advantage, we'll have higher profitability. In any market where, for example, there are three roughly equal sized firms, then we would have less profitability. So it's not so much US versus non-US [referring to a question on Netflix’s international expansion]. It is relative scale in each of the markets. And that's part of why we're investing so aggressively to be early and to lead this market in as many markets as we can.”
In pursuit of this, Netflix went out and licensed TV shows and movies for its leading streaming service. They signed deals with Miramax, Walt Disney Studios, and Time Warner. By the end of 2013, Netflix had accumulated a whopping US$7.3 billion in content liabilities.
Around this time, Netflix realised that it had an emerging problem. Initially, they could rely on licensing programming from multiple original content providers, secure in the knowledge that such providers would not launch competing streaming services against them. This knowledge was informed by the nature of the content provider business — where the bulk of their revenue came from licensing TV programming to the cable services. When seen from the perspective of a content provider, Netflix was merely one of several competing customers for content. They were no different than the cable customers that made up the bulk of their licensing revenue. And there was no good reason for the content providers to get into the streaming game — doing so would simply jeopardise their relationships and revenue with their cable customers.
However, as time passed and Netflix solidified its scale advantage, streaming services as a whole and Netflix in particular began to eat into the cable television market. This came to be known as ‘cord cutting’ — the phenomenon of TV viewers cancelling their subscriptions to multi-channel cable television in favour of internet streaming services. In 2012, for instance, equity research house Sanford Bernstein reported that the pay-TV industry saw a quarterly subscriber decline for the very first time in its history in 2010. Subsequently, it experienced five different quarters of subscriber declines. These reversals were stunning to an industry that had never experienced anything other than strong subscriber growth.
As cable subscriptions slowed and then reversed, original content producers like Disney and HBO began to look into starting streaming services of their own. Netflix saw the writing on the wall earlier than most: they realised that if their content providers got into the streaming game, they would likely pull their programming off Netflix, causing the service to lose its differentiation and perhaps even its scale advantage.
This was not to mention the bidding wars that Netflix was already embroiled in — caused by the entrance of multiple competing streaming services. As a result, Netflix began an aggressive pivot to content production in the early 2010s. As Chief Content Officer Ted Sarandos put it in 2013: “the goal is to become HBO faster than HBO can become us”.
Netflix’s increased focus on original content was marked by the launch of their first proprietary series, House of Cards, in February 2013. The company had reportedly paid US$100 million to develop the first two seasons. To put this in context, it may be reasonable to pay US$100 million for two seasons of a top-tier, award-winning TV series if you are a large, experienced studio. But this was Netflix’s first attempt at high quality original programming! They had shovelled a huge proportion of their current and future earnings into this one series. Equity analysts calculated that House of Cards cost close to US$2 per share (with 56 million shares outstanding) while the company had only earned 29 cents per share for all of 2012.
To fund this level of spending on original content and on licensing fees, Netflix had to raise huge amounts of debt. It did so by offering non-investment grade (junk) bonds. At the end of 2013, the company had issued a total of US$500 million of bonds … and they issued another US$400 million for the first quarter of 2014.
Was this rational spending, or debt-fueled excess? On their part, Netflix believed that their leadership in subscriber count gave them the ability to spend these large sums of money in producing original content. Their cost per subscriber in developing House of Cards was about US$2.75 with 36 million Netflix subscribers at its premiere. If Hulu was to spend an identical US$100 million in producing its own original content, their cost per subscriber would be a much more prohibitive US$25 with 4 million subscribers in 2013.
In October 2015, Netflix expanded into producing films, with the launch of their first original feature film, Beasts of No Nation. In December, they followed it up with the star-studded film, The Ridiculous Six, starring Adam Sandler. And the company was just getting started. By 2019, they were releasing an average of one new original film or TV series per day, for the whole year — eclipsing what the entire US TV industry produced for 2005.
To fund their hefty investments in original content, Netflix leaned all the way into the junk bond market. This was — to be clear — not an unalloyed good. Critics referred to the company as “Debtflix” as their debt ballooned from US$1 billion in 2014 to US$16 billion in 2020. In 2019, the company became one of the largest issuers in the U.S. junk-bond market, at 11th place.
By the end of 2020, Hastings alluded to the end of the “Debtflix” era. In the Q4 earnings report that year, Netflix wrote — in bold and italicised font — that there was no longer “a need to raise external financing for our day-to-day operations.” Their debt would be maintained at a range of US$10 to US$15 billion going forward. After the announcement, Netflix’s stock surged more than 12% in after-hours trading.
As of this writing in Q2 2022, Netflix has US$14.3 billion worth of long term debt, after paying down more than US$700 million in senior notes. While competition remains fierce, it appears Netflix had bought themselves a moat.
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