The End of Streaming's Golden Age

It was all a dream, now I see commercials on my screens

As most of us have forgotten, Netflix started as a competitor to Blockbuster. They mailed out DVDs to folks who had requested them through an online portal. Their big break came when home internet speeds reached the point where HD streams were possible. The company quickly shifted to on-demand streaming and the DVDs went the way of the dodo bird.

The business proposition of Netflix was pretty simple at that point. Customers would pay a relatively low monthly fee for access to a library of content on the application. The company would then take that money and secure increasing amounts of content. It was a volume play. More people meant more aggregate money which meant more content which increased the value proposition and therefore more people showed up to the platform.

Content owners were more than happy to rent out their goods because otherwise, they were just sitting on inventory that traditional broadcasters did not think much of. A cable channel has to actually play content while Netflix could pay a fee, have it sit on the app, and not overly care whether or not anyone watched it. The point was to just have shit that people could scroll past interspersed with captivating titles.

In time, content owners realized that maybe it would be more lucrative to take their own assets and put them up on a streaming service that they at least had some level of control over. At the very least, content owners began to realize that maybe they had more power than they had previously thought – a rising tide lifted all ships.

Netflix, for their part, realized this dynamic as well. The only way to get around the content-owner gatekeepers was to create their own content. This content – at least initially – had to be high quality in order to draw subscribers into the platform through the ‘must-see TV’ effect and to position the platform as a quality item at a discounted price. In came Orange is the New Black, House of Cards, Chef’s Table, Stranger Things, and now seemingly endless streams of travel/cooking shows, romantic comedies, and true crime documentaries.

In their quest for streaming domination, Netflix engaged in what I called the ‘Uber cash incineration strategy.’ This strategy consists of tapping low-cost external funding sources – both debt and equity – to juice the value proposition of service beyond what existing and new users pay. The idea is that by being so star-spangled awesome, everyone and their dog will become a regular (or subscribing) user. Doing so is a winner-takes-all approach because the firm with the deepest pockets is the one who can offer the outsized benefit the longest and thereby hoover up all the customers. Once a platform has all the users it can then up its fees since there are no competitors left.

The reason I call this strategy ‘cash incineration’ is that it’s a terrible strategy. Business is a competitive marketplace where most outsized returns to companies are competed away over time. The second that a Netflix or Uber no longer provides the benefit its customers are used to a market opportunity emerges for another schmuck to come in and try the disruption game all over again. However, even if the business value goes to zero in the long run, in the short term there’s money to be made so this behavior remains motivated.

Anyways, as you may or may not know, content has gotten very expensive. Or rather, top-tier content that drives user loyalty has gone through the roof. Netflix lost Friends after paying $100-million for an additional year of rights in 2019. They then replaced the show with Seinfeld to the tune of $500-million over five years. Around the same time, The Office was pulled off the platform in the US despite Netflix being willing to pay $90-million a year for it.

In the realm of original content, Netflix has thrown swimming pools worth of gold at major showrunners in the hopes of driving engagement and capturing eyeballs. Shonda Rhimes has a deal that could run into the $350 to $400-million range in its current form. Meanwhile, Ryan Murphy has grabbed around $300-million for himself. While Shonda has given the platform hits in the form of Bridgerton and Inventing Anna, Murphy has more or less done jack shit.

Over the past three years, Netflix has spent over $13-billion, $11-billion, and $17-billion on ‘additions to content assets.’ For context, General Motors spent $7.9-billion, $6.2-billion, and $6.8-billion over those same years on research and development. Before anyone says that Netflix ought to spend more on asset creation because it’s a high flying tech company, I’d point out that Tesla spent $2.5-billion, $1.4-billion, and $1.3-billion over those years while Microsoft spent 12% of revenue in 2021 on R&D which at Netflix’s level would equal around $3.6-billion.

The short of it is that Netflix spends a lot of fucking money on content. So much so that it has had to come out publicly and say that it will stop chasing after vanity projects. As I type these words Netflix’s stock price is down 70% year-to-date.

Now is probably a good time to talk about the structural factors shaping Netflix’s rise and apparent fall (for now).

Netflix got lucky in that its growth occurred during a time of extremely low capital costs. This meant that they could tap capital markets at world-historically low rates. They are currently sitting on $15.5-billion in long-term debt principal obligations.

The firm’s borrowing rates have been in the range of 3.625% to 6.375%. These borrowing rates are about equal to those of a high-credit score individual buying a house. This is relatively wild given that despite being senior notes, the bonds are not secured by any specific assets. At most, Netflix content assets would be carved out and resold to other streamers. Except of course that a crisis at Netflix would likely lead to – or occur in tandem with – a general industry panic thus reducing near-term market values on the content. Fixed income folks can tell me to pound sand at this point, so I digress.

The actual point of importance here is that Netflix’s cost of capital was low – as was basically everyone’s minus a few resource sectors – over the last 15 years. This meant that for the investment bankers and equity analysts the denominator on valuation models (i.e. the factoring in of the time value of money) was exceptionally small. The result is that recurring cashflows occurring well into the future appeared to be worth a lot today. The resulting ‘fair’ value of these future flows was even larger given the fact that finance folks are prone to outrageous CAGR estimates. At some point, you run out of new subscribers and existing ones will only pay so much for decreasing amounts of new content.

This leads us to the myth of innovation. I am on the record multiple times – some say far too many – claiming that innovation as currently peddled in the market is nothing more than cheap capital covering up old business models.

Let me use Uber as an example. Why? Because I hate everything about Uber other than its ability to drag me from the airport to my hotel.

Uber used to be a premium product. When it started you could get town car service for almost no money. It was ridiculously awesome. But this was only because Uber HQ was covering the bulk of the fare. You paid a little, corporate paid a lot, and the driver got a large payout. In time, the drivers got gouged thanks to HQ paying less and less. At some point, the drivers began to rumble about their shitty economics so HQ began to raise rates from the perspective of the customer.

Now, Ubers are more or less the same price as a cab. You can see this in the quality of service as well. When Uber was new, all the cars were shiny and basically fresh off the lot. Now, you get 10-year old Camrys with absent rear suspensions.

My guess is that barring an autonomous vehicle genocide of the driver market. Uber is going to institute a ‘preferred driver’ program whereby they will limit the number of drivers in a geographic area. The drivers will be selected based on utilization rates. These drivers will be guaranteed a restriction on competition – leading to higher fares. In return, Uber HQ is going to ask them to pay for their monopolistic positions and other ‘services’ that HQ provides such as access to the app. If a driver’s utilization rate drops below a certain threshold then they will no longer be able to pay the HQ fees and new drivers will be afforded the opportunity to enter the market. If this doesn’t sound like the old taxi medallion system then you haven’t been listening.

As mentioned above autonomous vehicles would make things different by eliminating the driver component but Uber (or another platform) would still be incentivized to limit the number of vehicles operating to ensure adequate return on the outlaid capital for the vehicles in the first place.

In short, contemporary disruption and innovation consist of taking cheap as shit capital, using it to subsidize users so as to garner a customer base, and engaging in capital attrition with competitors, only to then revert to pre-disruption business models that were proven to generate profits.

The likes of Travis Kalanick did not care that existing business models generated outsized profits. What they cared about was that they were not the ones collecting those profits. We all just gave them the capital to divert the funds their way. Don’t even get me started on how the FinTech, Web3, and crypto bullshit all vibe with this narrative arc.

But back to Netflix. Netflix followed the cash incineration strategy to run the likes of Blockbuster out of business. They became the movie rental place. Then they moved into content creation and thereby became effectively a broadcaster. But of course, their sales pitch was that they were actually a tech company. The problem with that statement is that their tech was – as far as the customer was concerned – more or less the same as an ABC, CBS, or NBC. You sat on your ass at home and watched content on a screen.

To their credit, Netflix offered flexibility, choice, and the ability to avoid commercials through subscriptions. To that extent, they were an on-demand HBO. This comparison is validated by the fact that their original in-house content (like House of Cards) directly competed with HBO content when awards season came around. Yet no one with three brain cells pretends that HBO is a tech entity.

In order for Netflix to have a viable future in its current form, it has to continue to have cheap capital coming to it from all directions and have access to it in ways that competitors do not. The problem for them is that the likes of Amazon, Disney, and Warner Brothers also have the ability to pump out over-paid-for content. In this mad dash to be the last one standing, Netflix might have just blown too much, too early. The time to cut content creation costs is not when your main competitors are just getting into the swing of things.

Netflix, therefore, is looking around at how the hell to get money through the door as growth slows in the face of rising competition. It is therefore unsurprising that they are looking at bringing ads onto the platform. Sure, initially the ads might only be for a cheap user plan option but in time they’ll make their way onto the regular plans. Perhaps there will be an ad-free option for double the price, but that’s ignoring the basic fact that ads are coming. What’s next? Scheduled programming? Oh, wait....

If you use streaming services you have probably noticed that increasingly shows are being released in batches or one episode at a time. The days of the one-day binge-watch are coming to a close for new releases. The reason for this has nothing to do with user experience. Instead, what is happening is that Netflix has to convince you that they provide month-long value. They can’t do that if they do not have a 10-hour blockbuster show coming out every two weeks. Instead, they take content that used to last you a week and break it up into segments so that you come back every single week. Thus creating the illusion of long-duration value when your eyes on-screen time is actually lower because now there’s just less hot new content being dropped. Oh, and there’s more going on with that than you might think.

The reason why Netflix (and others) are scheduling content releases in batches is for the purposes of coming up with advertising models. It is very hard to sell a premium ad space for a show that everyone is going to watch in one weekend. It is much easier to be able to sell ad space that runs over the course of a month. You have Show X brought to by - I don’t know, Clorox? – and the assets are seen in an even manner over the course of a month. The ad assets don’t just get seen by the bulk of the audience on release day but are viewed by enthusiastic eyes week after week.

In terms of what is actionable here, you can look at Netflix and compare it to a mix of Comcast and Warner Brothers for valuation purposes. They create content and own the platform on which you consume the content. You then have to factor in low user growth and the effects of moving to a – at least partially – ad-supported model. You have to value it like a media company, not a tech firm. Even at a current massively down market capitalization of ~70-billion I don’t see why it couldn’t or shouldn’t go lower. With that said, if Netflix’s pure-play streaming business declines in value so too will the conglomerated offerings from Disney, Warner, CBS, et al.

One last thing, this phenomenon is also happening in music streaming. Look at Spotify. I pay X amount a month (I honestly don’t know) for an ‘ad-free’ experience. However, when it comes to podcasts I’m okay with ads that are in the episode because those shows have to make money. However, ads run in Spotify-owned podcasts such as those from The Ringer. Now, I might be able to overlook them if they are read out by the host as a presenting sponsor or something but now they are running generic blocks of ads before and during the episodes based on my geography. Which, call me crazy, seems ridiculous for a subscription service. Spotify is double-dipping into the money pit. Much like Netflix is looking to do.

All this disruption and all we’re going to have to show for it is talk radio and traditional broadcasting.

Just Finished: The European Guilds by Sheilagh Ogilvie

Currently Reading: The Grand Strategy of the Roman Empire by Edward Luttwak

Up Next: Jacobites by Jacqueline Riding