Rob Fagen

Rob Fagen
Contributor since: 2011
They do have a moat, though: the network and relationships they foster between content sellers and content consumers.
It's easy and efficient for a seller to monetize their content and it's easy and efficient for a consumer to find and pay for it.
I wrote an article about five years ago that covers why this is a moat and compares Netflix to a company that has a similar history and modus operandi.
I don't know your background, but you write in a manner indicating first-hand experience with the specific practices needed to be successful in China.
Even given that, I had a vague notion that I could take your article, do a search and replace of "China" with "studios" and perfectly express the industry consensus on whether Netflix would be able to get the licenses necessary to move from DVD to streaming in a meaningful way.
People think of Netflix's core competency as being movie delivery. That's literally the tip of the iceberg. Netflix's core competency is really the negotiation of IP licenses. That said, there is one parallel between the way you lay out the obstacles in China and how Netflix solved the DVD->streaming transition. Netflix had to partner with Starz to be able to establish a viable catalog for streaming and create the space. It may well be that partnering with a local authority would be an easier and faster road to a presence in China.
However, I am reasonably certain that Starz was seen as a partner in creating a completely new market segment. I've got a hunch that your characterization of seeing a local authority as an inefficient (or as you say 'corrupt') obstacle to progress is very much in play here.
The balance to be struck here comes down to which is stronger: China's consumers' desire for a Netflix branded media experience versus China's government's desire for control (both economic and cultural).
Long term, I'd bet on the brand (as I have done for the last 12 years).
Guinness is $190 per keg? Talk about a bubble! Well, I suppose that's about $2 per pint, which doesn't sound so bad.
Please check out Dan Rayburn's very insightful (and possibly more accurate) take on this event.
The key point is that Netflix is going to be paying Comcast directly for what they previously have paid only Cogent for. Additionally, Netflix will now get a contractually defined level of service, which it hasn't been getting from Cogent.
I think the actual tally is:
Comcast: mostly win (more revenue, but with greater obligation)
Netflix: win (better customer experience, and maybe lower cost)
Netflix customers: win (better streaming)
Cogent: lose (less revenue)
@nanonerd: I think you're thinking in the right direction, but still haven't thought it all the way through. The key for me to realize that was when you said "will Netflix make profits of $5.5 billion over the next 3 years to cover the streaming costs".
Netflix doesn't have to make $5.5b in *profit*. They have to make $5.5b+gross margin in *revenue*.
They have subscribers today. Some percentage of those will be lost to attrition. Some percentage will be gained through acquisition. Either way, in order to cover these *future* expenses, Netflix needs to bring in $2-3b per year in each *future* year. This translates to 20-30 million customers.
That's what I was saying about matching the off-balance-sheet liabilities with the off-balance-sheet assets. The subscriptions that haven't yet been paid (but are very likely to be paid except in the case of a total disaster) are the asset-flipside to the contingent liabilities that are being recognized off-balance-sheet.
I may not be expressing myself clearly, and if so, I apologize.
As I posted above:
These payments are currently liabilities and when the content actually starts being used, they will be an expense. Netflix won't need to raise debt financing because there will be income to offset the expense when the expense arrives. Netflix is currently managing it's level of expenses for content quite well and, as the article notes, has recently returned to better profitability.
I agree that the so-called "off balance sheet debt" looks odd. However, when you think it all the way through, you need to offset it by the "off balance sheet assets". The future obligations to the content owners are offset by the future expected revenue from customers.
These payments are currently liabilities and when the content actually starts being used, they will be an expense. Netflix won't need to raise debt financing because there will be income to offset the expense when the expense arrives. Netflix is currently managing it's level of expenses for content quite well and, as the article notes, has recently returned to better profitability.
I agree that the so-called "off balance sheet debt" looks odd. However, when you think it all the way through, you need to offset it by the "off balance sheet assets". The future obligations to the content owners are offset by the future expected revenue from customers.
See my other comment ( in light of this information about OpenConnect lowering bandwidth charges for transport to end customers. Looks like my assertion is actually relevant.
Regarding bandwidth bills, I would possibly expect ISPs to be frustrated, but I'd be surprised if there was a material difference to Netflix's bandwidth bill. My understanding is that they solve this with peering agreements and CDN magic. There will be some additional bandwidth to seed the content, but after that, it should all be very low cost or free.
You're generally very thoughtful. I know you're not a journalist, so I shouldn't expect a bias-free view. However, "This isn't the first time Amazon has taken advantage of Netflix's penny pinching" and you cite Netflix letting Epix exclusivity lapse there specifically, and the fact that Netflix dropped A&E content prior to Amazon picking it up is the basis of the article (implying that it was all the content).
Netflix cherrypicked the 300 hours out of the 1100 hours of A&E that were contributing economically to the streaming efforts. Amazon picked up all the rest (ironically including the stuff to do with pawning and storage -- where useless stuff goes to die).
Epix wasn't dropped, just the exclusivity.
I guess my point is that you're painting a harsh picture of desperation and/or incompetence that could also be described to shrewd content management decisions.
I continue to marvel at how, like every generation of teenagers thinks that they invented sex, there are folks continually discovering and dismissing Netflix's seasonality.
There's been a Christmas spike since forever. There's been a summer lull also since forever. There's generally a run-up in the stock price following the Q4 & Q1 conf calls which settles back over the following month. There's generally disappointment around the Q2 & Q3 results. Of course, all of this was masked recently by the feverish rise to 300 and subsequent fall to 50.
As always in life, the answer is somewhere between the extremes. 300 was too high, 50 was too low. At this point, with the prospects of global streaming, I'm happy to call anywhere in the 70-100 range just right.
Have you considered that the percentage drop in earnings is due to planned investment in expansion of the business? You've touched on that issue in prior articles but from this comment it doesn't seem like you're connecting the dots.
Think of Netflix as the world's largest startup and they're operating on the edge of profitability on purpose. That purpose being capturing the larger prize of $5 per month from a billion global streaming customers with 10% margins (as opposed to focusing on the $9 per month from tens of millions of domestic DVD customers with 40% margins).
I'm sure you've read Innovator's Dilemma. Netflix has been very busy building the business that will gut its own legacy business before someone does it for them. They've also been pretty transparent about what they're doing and the financial effects.
This is half-snarky, half-serious: Didn't NFLX actually reach $300 before crashing? Give him some credit for hitting the target. He probably didn't say it would *sustain* at $300, just get there...
I come back from vacation and see that NFLX raised money last Monday. I guess IOU one beverage of your choice.
I was pretty close to getting off, though :)
That wouldn't happen to be Schrodinger's cat, would it? That's about the only cat that would be smart enough to do it that I know of. Even if it is, then he may or may not be able to start its own streaming service. Actually, you wouldn't know if it did start a streaming service until you tried to look at the cat's financial statements of operations. At that point, maybe it becomes Bilton who does or doesn't exist. :)
Do you have a link to Netflix's announcement that margins are going down because of increase content costs? The only thing I recall recently was Well's comments at the BofA/Merrill Lynch conference where he suggested that the deals being discussed today (including Starz) are all falling within the 14% gross margin target.
That's for Blockbuster by Mail. How exactly is three free months of one disk at a time (only if you sign up for $25+ a per month Dish subscription for two years) supposed to unseat Netflix?
You're right, I should clarify. When I said "in a profitable manner", I meant that Netflix can offer those payments to content owners with reasonable confidence that it is a profitable decision for Netflix.
I don't have any internal documents or knowledge to substantiate this. I'm extrapolating from past behavior patterns that I observed first hand, and assuming that while the context has changed (was DVD, now is streaming), the actions are the same (purchase and deliver content only when it's profitable to do so).
I agree with you that any number of cash-rich companies could subsidize an equivalent service (at a significant loss) in an attempt to unseat Netflix. However, those cash-rich companies didn't accumulate that pile of cash making bets like that. They made their pile by executing relentlessly in an area in which they were expert (Apple->hardware & style, Amazon->logistics,G... with search and ads).
I don't see anyone stepping up as a life-threatening competitor to date (e.g. able to fulfill predictions of Netflix bankruptcy in 2012). The closest I've seen is Amazon with Prime. If Amazon can focus, iterate and improve to the extent that they significantly overtake the quality of Netflix's service (not just parity), then maybe we'll have a Coke/Pepsi kind of matchup some time in 2013. That's a long time for Amazon to invest in a losing business, especially when they've got other profitable ones that they could be paying attention to.
Right. They care about the check. Netflix is the only one that can offer checks of that size in a profitable manner. Every other purported competitor would be savaging their own earnings to cut equivalent deals (even with the 'scaled down dollar value because of the smaller number of subscribers' effect -- the competitor at the smaller scale wouldn't be able to offer the service efficiently and cost effectively).
See my slightly impassioned (and M&M driven) response to Milkweed above. Content owners will come to Netflix. Content owners will love capitalizing on content that nobody but Netflix can sell profitably.
Netflix is one stop shopping for folks that don't care about HBO (like me and the 80 million households in the U.S. that don't subscribe to HBO.
Of course it occurred to me that nobody but Netflix could *profitably* and *sustainably* do this depth of subscription offering for $8 per month. That's the key. Netflix is doing it profitably *today*. They continue to grow the business internationally in a sustainable fashion *today*. This is because they:
1. are in all the devices
2. are in partnerships with a huge number of content providers (and no one content owner can hold them hostage)
3. are insanely efficient at leveraging technology
4. have unbelievable piles of consumer preference data about entertainment and the analytic engines to mine the gold from them
Note that I didn't say that "nobody but Netflix can do this". The very important word is "profitably". Netflix is out front and running away from all the competitors, and every new content deal they do is expected to add to the bottom line, or they wouldn't be doing the content deal. Every new country they enter will accrue to the bottom line, or they won't go there. Anyone else that comes in has to factor in the bloodbath to their bottom line until (or even if) they figure out how to do subscriptions profitably and at scale.
Any number of businesses could get started today and crush Netflix if it wouldn't be a phyrric victory. Nobody has the will to do it. To be cliched, read your Sun Tzu -- think about whose will has been sapped. Think who is bringing the fight to the territory where they're strongest. Netflix has the will and the expertise to stay out front and be increasingly profitable every day they're out there.
If I may wax hyperbolic and mix several movie metaphors, Los Gatos has three buildings full of frigging sharks with lasers on their heads swimming around in the entertainment ocean, and any e-tailer that tries to get in on this business will need a *much* bigger boat (or maybe even an armada).
Not sure if I've pointed this out before to you, but a huge part of the value proposition for the consumer is the all-you-can-eat and under-one-roof aspects of the subscription service.
In your examples of iTunes cross promotion, that's all pay-per-view, a totally different market. Netflix doesn't necessarily need this kind of cross-promotion because they are known as a first-class aggregator and are increasingly drawing subscribers because of the improvements in the catalog (instead of getting people hooked on the unmatched DVD catalog and then getting them to try streaming).
(damn, I've used a lot of hypens here...)
Anyway, all of the studios trying to go it alone with their own over-the-top subscription service would result in a balkanized landscape of consumer confusion. Netflix's future is tied up in how well they can become the Walmart of streaming -- everything you might ever want under one roof at an incredibly good price.
Nope. Not making it up. Taking publicly available information and extrapolating. I'll own up to my memory being a little faulty in the past on some of the numbers, but I'm pretty certain on the 80/20 split between international and domestic. I'll try to find a link to it.
Thank you for the kind comment, and you raise an interesting point regarding "where do we go from here". I guess I don't have a really good story for what the future has in store.
I'll be relatively open here. I've got a block of employee option grants that are expiring early next week, so I'll be selling those this week. I've got about 3x as many that I accumulated after the plan was changed to allow for a 10 year post-employment expiration date instead of a 1 year expiration. I'm holding on to those indefinitely (or until 2017 when they start to expire).
Your 240->350->crash to 300 is an interesting scenario. I guess my planning horizon is really six years out at the point, which is why I'm planning on holding on to that second block of options as long as I can.
Thinking back to 6 years ago, Netflix was a couple million members. The idea of hitting 5 million seemed ridiculously far away, yet it happened (and we had a pretty good party in the Santa Cruz mountains). The idea of hitting 10 million was some kind of crazy dream, yet it happened (and we had a pretty good party in the courtyard of the office). Nobody was even talking about 20 million, but it happened (and there was a party that I didn't get invited to, but I hear it was pretty good).
Now think about an assertion that Reed made regarding his future vision of Netflix being 20% domestic and 80% international (I'm too lazy to go look up the attribution -- I did a quick google search but came up blank). I think it's ridiculous, but just how much do you think Netflix would be worth if it were pulling in $1 billion *per month* at 14% gross margins? If I did my envelope scratching correctly, that's on the order of $30 per share of annual earnings. At a PE of 10, that's $300 per share.
Like I said, 120 million subscribers, with 4/5ths of those outside the US seems ridiculous to me from where I'm sitting today, but it's a hell of a lot more plausible than a lot of plot twists I've seen up on the silver screen. I won't be invited to the 100MM party, but I can imagine it will be quite the blowout.
I was referring to my earlier article comparing Netflix to Visa. Both companies are sitting on top of a pipeline of cash transactions, from which they dip out a small fraction of the flow. As the flow increases (credit card transactions for Visa, increased subscriber's monthly fees mostly getting directed into purchases of content) the overall revenue increases. As long as the size of the cash flowing through the business increases at a greater rate than costs of servicing that flow, profit increases as spending increases.
I was around for internet bubble 1.0, and I've acknowledged before that maybe we are repeating that pattern. The difference here is that we've got an aggressive valuation being put on a company that is profitable and growing earnings in a very well managed and controlled manner. This is in contrast to bubble 1.0 where everything was a loss leader and spending for eyeballs made sense. Here, every Netflix spend is evaluated beforehand to understand if it is materially likely to drive incremental profits. The more Netflix spends, the more Netflix earns.
Dear Fil,
I don't think anyone at Netflix really cares about what effect international expansion has on the stock price. My guess is that everyone there is focused on making international happen as quickly as possible because initial testing (Canada) has been wildly successful, and the sooner each step is taken towards worldwide distribution then the sooner it's going to start adding to the bottom line.
Good article (well written, as always, well researched, as always). I didn't mean to be taking a cheap shot at Mr. Pachter, I'll own up to not having paid close attention to all of his research over the years and selectively remembered only the ones that were farthest off given 20/20 hindsight. For that, perhaps I owe him an apology for the offense (btw, my last name is fagEn :) ). Back to Netflix's model, I guess the thing that I haven't been able to make too clear is that while the content costs look like an anchor, they're really a jet engine.
I tried to make the point in my earlier article ( that Netflix is in a position to be an indispensible middle-man. Through the power of the preference and usage data collected over the last decade, and through the insights gained using their proprietary analytic engines, they can skim a small percentage of the flood of cash going from their subscribers through to the content owners.
Because Netflix generates wholly new demand, the incremental revenues they provide to the studios make them giddy. Because Netflix is so good at building efficient, automated, scalable solutions that can provide instant entertainment to millions for a fraction of what it would cost through other channels, they own an army of monthly-check-writing consumers that Netflix can use as enormous leverage in getting content that brings in ever more consumers.
I have no crystal ball that guarantees this future. I am just pointing out patterns that I've seen in my past that I think we're repeating in a new space. I think the pattern we're repeating is that of a technologically innovative intermediary taking a small fraction of a new and growing gigantic cash flow and profiting handsomely.
Don't be obtuse. If the options are expiring, you'd rather that he let them expire worthless instead of exercising for the last seven years in a controlled fashion? I think it highlights the foresight and planning (dare I say engineering focus) that Reed and the rest of the CxOs apply to business problems.
I don't know him personally, but his LinkedIn profile shows him at TCV, plus a couple of board positions.
I think most of the options getting cashed out today are from 10 years ago. I think holding on for 10 years is a pretty strong vote of confidence. I think having all the other C-level execs taking on the order of half their compensation in options is also a pretty strong vote of confidence.
Like I said in reply to your prior comment, pre-IPO grants are going to be set at the best estimate of enterprise value. Anything after the IPO has been set at market price on the day of the grant.