Netflix and the Big Mistake

Way back in the 1980's, before he was a washed up politician, Arnold Schwarzenegger made a career out of spouting corny one liners.



In perhaps the greatest (Arnold movie anyway) movie ever made, "the Last Action Hero," Arnold told Claudius he made a "Big Mistake." Right now, Netflix is making a big mistake. The Christian Science Monitor thinks Netflix is creating Qwikster just to sell it. Again, Big Mistake.


America is not ready for streaming, and may remain unready for decades to come. Streaming requires cheap and easy bandwidth, which in turn requires a lot fat, high-capacity connections to the average consumer, already paid for and competing with other connections to offer low cost connectivity. Most internet service providers have usage caps, that impose fairly high fees past certain amounts of downloaded data. Heavy streaming of movies will blow past those caps and make the cost of connecting to the internet very pricey. That's a dubious proposition when people are buying cable packages without ESPN to save $30 to $40 a month.

America is a big, spread out country. Unlike mostly urban places where Netflix has expanded (Canada, Argentina, South Korea), most people in America still live in spread out suburbs. It will take a long time for high speed internet to be built out to those areas, and even longer for the data pipes to be fully paid for, and face competing connectivity offerings. Yes Amazon, and Google, and other people are thinking of offering their own data plans, but let us be realistic. Are they able to cover people in suburban Dallas, Phoenix, Atlanta, Chicago, and St. Louis? Plus everywhere in between?

Then too, Netflix faces extremely high costs in signing content deals for streaming. While Netflix can simply go out and buy DVDs if it has to, and has done so (as has Redbox), for a fixed and limited cost, and rent those discs out, streaming the content requires very pricey arrangements with content providers. Who having rapidly diminished revenue streams from TV sales, DVD sales and rentals, no real bump from Blu-Ray, and not much from global ticket sales or 3-D, are not in the mood to do anything but raise prices or build their own streaming center. [This is short-sighted, and guarantees piracy the way the lack of Itunes in the fragmented, Napster era guaranteed widespread music piracy, but that is another story.] Hollywood needs to make money, and they figure on doing it through streaming one way or another.

Meanwhile, those people wanting high definition video, or 3-D (for those who have it) will find Blu-Ray discs far more friendly. You can stop it and watch when you want, there is no stuttering or jitter on limited bandwidth networks, no pricey bandwidth cap fees, and the family can watch as much as it wants before returning the disc.

Yes, the troubles with the Post Office make the costs of the physical disk market potentially higher, but far lower than the endlessly increasing streaming. In a far-flung nation like the United States, the advantage of delivering entertainment on a physical disk still outweighs that of a network.

Yes this is the old "floppy net" or "sneaker net" way of moving files around, on a physical disk hand-carried to device that can read them. In this case, not computer files but DVD and Blu-Ray discs. This business model still works, generates a lot of cash, and will for quite some time.

Reed Hastings is still living in the mini-dot-com boom. When Facebook and Groupon were valued at billions despite not turning a profit at all, apparently. People don't have the money, to spend on pricey streaming plans. No matter how convenient they are, business-wise, requiring almost no people. Hastings can obviously see, "hey no mailing centers, no people opening and sealing envelopes, very little in the way of employees, hey cost savings." That's diving for nickels and dimes and ignoring dollars on the table. Anyone can open a streaming business, heck why wouldn't content owners go with Hulu, many of which are still partners in the deal, or Amazon, or Apple, or Microsoft, or any number of partners who can give them a better deal?

Meanwhile Netflix already has loyal customers, who have liked and used the DVD by mail rental service because of its cheap price and wide selection. To get into that business requires opening up and training employees to operate mailing centers, regionally. It requires lots of publicity and marketing. Netflix has a lot of expertise running their mailing centers, which are the core of their business. None at all really running streaming which places like Amazon, Apple, Microsoft, and Hulu know a lot better than Netflix.

Sometimes nobody here can play the game, as Casey Stengel said of the hapless Mets. Or, "Big Mistake." Maybe even, "Not to be!"
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Netflix's Choice and the Return of Louis B. Mayer

The usually reliable Edward Jay Epstein has a new column up at the Wrap detailing the transition Netflix is undergoing. Netflix currently spends around $500 million a year in postage mailing out DVDs and receiving them back. This also requires obviously, distribution centers, and along with an average price of $15 per DVD, accounts for operating profit of about 12%.

Steaming, obviously, is cheaper. No postage fees, no rate hikes in postage, instant gratification. The only problem being that Hollywood is charging premium prices for streaming rights (Netflix can simply buy DVDs from wholesalers and rent them out without costly rights fees). As Epstein notes:

The brutal reality is Netflix’s bargain days for streaming movies and television is coming to an end. As everyone else in the licensing game, Netflix will have to pay real world prices for content. Just the output deal it announced with three of the weakest studios, Paramount, LionsGate and MGM will cost it $200 million a year, a sum that exceeds its operating income last year. And if it wants the kind of output deals the other pay channels have, it will have to pay a great deal more than that.

Of course, Netflix can do something else. Create its own content. Which, in order to make money, would have to be very popular. Yes, HBO, Time-Warner Cable (HBO's Parent), Amazon, Itunes/Apple, Hulu, Google/Youtube, are all Netflix competitors, as Epstein notes. Competing on price for streaming, and on every platform: smartphones, Ipads, tablets, TV sets connected to the internet, gaming devices, and more. Netflix very likely has few illusions on this matter. But … they can create their own content.

And that can be their great competitive advantage.


Most entertainment is junk, which also loses money. Hollywood's movie system depends almost entirely on a few mega-hits: Transformers, Iron Man, and other male-oriented action movies, along with Twilight, and a few other female oriented romance movies. Stuff like "the Reader" or "the Woodsman" or "Ghost Writer" don't make money, even if they do win awards and get Hollywood's execs their next job (by catering to stars egos). Among TV series, a few mega-popular reality shows like American Idol make a lot of money (American Idol is estimated to add about $200-$300 million to Fox's bottom line). The repeat value or desire to see these on devices other than TV, live, is fairly low, however. A few other shows like NCIS, and Desperate Housewives, generate high ad dollar purchases by sponsors, and thus make money. But again, the desire by consumers to purchase these shows is fairly low.

What Netflix can do, then, is exploit the gap in broad entertainment people will pay modest amounts to view, by creating their own. Epstein, like many in and around Hollywood, over-estimates the barriers to creating original content. And the sea change a producer like Netflix which cannot survive in the Hollywood model and MUST create broadly popular entertainment across its offerings to prosper against a host of rivals. Which, amounts to a return to mass culture, and the end of niche culture and "de-massification."

Netflix is not HBO. HBO depends on keeping heads of households "happy" by offering female-skewing "edgy" content not available anywhere else. Alpha males in full a-hole glory: Tony Soprano, the folks of "Rome" and so on. HBO, of course, is available in almost all TV households but less than 30% actually pay for it. HBO gets paid if people watch their content or not. It's been very profitable, but depends on lots of excess cash among high income consumers expressing a desire to be "different." Making it vulnerable to economic downsizing and consumers being pressed into dropping the service (and cable altogether). Cable cutting, a real phenomena, is already occurring at the lower end of the income spectrum, as the cost of living inflates while income remains stagnant.

HBO depends on a large pool of high-income consumers expressing their niche content desire by paying premium prices for niche content consumption. That is not Netflix's mass consumer model. Near-premium cable folks like FX, or AMC, rely on keeping their channels as part of the basic subscription model, and thus follow HBO's model: AMC's Mad Men and Breaking Bad (Alpha male assholes appealing to women), or Nip/Tuck, Damages (Alpha female) fit that model. Mad Men famously got less than 1 million viewers per episode the first season. Yet it was considered a massive success (generating lots of publicity) and was easily renewed. Because AMC gets paid if people watch the channel or not. Again, that's not Netflix's model.

The limits of the HBO model (you cannot grow beyond the niche consumption of high end consumers) and the near-premium cable model of AMC and FX and others, come with risks of being unable to compete on price in a prolonged recession/depression. These entities depend like Hollywood movie studios and TV broadcast networks, on good times rolling not hard times a coming.

Netflix has always been different. Oriented towards mass consumer spending, not pricey niche stuff. Their play, and they are clearly edging towards it, is to create their own content. Aimed necessarily at the broad middle, and those willing to shell out modest amounts for entertainment: men. Yes, Netflix to compete will have to produce its live action competition to Call of Duty and Medal of Honor and Halo. Male skewing tales of adventure, excitement, and action-driven conflict.

Can Netflix do this? Certainly, and they must. After all, soundstages are for rent to whoever can pay. Actors, directors, writers, are all for hire. So too, are many locations outside Hollywood where tax incentives matter. USA Network has already leveraged this, with In Plain Sight shot in and around Albuquerque, New Mexico, and Burn Notice in Miami Florida. Male skewing writer/producer teams like Life's Rand Ravich/Far Shariat and 24's Joel Surnow can be hired. So too, comic creators like Jim Shooter (Valiant Universe creator) or James Robinson or Brian Michael Bendis or Micah Ian Wright. The idea being to produce not just one-off movies but serial entertainment streamed right to men who have other than video games, little competition. A price point of say, 99 cents per episode, or even free with embedded ads. So the male consumer comes back.

Clearly, just trying to make the next "Vampire Diaries" or "Parenthood" is not a way to success. No matter how many tween girls (or their moms) watch, or how many PC plaudits are earned. Netflix is interested in making money, and doesn't have a massive parent to subsidize making Hollywood players happy. Amazon, Itunes, Google/Youtube, and even Coinstar's Redbox can crush them. So whoever races to their own, vertically created, distributed, and sold content gets to replicate …

Golden Age Hollywood. Characterized by "Its A Wonderful Life" and "Yankee Doodle Dandy" and John Wayne and Humphrey Bogart. No metrosexual, "I Love You Philip Morris" stuff, or "TransAmerica." You didn't see John Wayne smooching Ward Bond, in a gay cowboy movie, or Rosalind Russell playing a trans-sexual man/woman. Everything was broadly pitched, straight to the middle, as content was owned, distributed, and revenue collected, by Hollywood's studios.

Hollywood was no less filled with hard left folks in the Golden Age. Heck, many writers and actors were outright members of the Communist Party, when it actually meant something and Stalin was alive. But the economics of the mass media, vertically integrated companies requiring mass sales not niche stuff for premium prices in one way or another meant you got Jimmy Cagney extolling the virtues of the Red, White, and Blue, not a metrosexual, stalker Superman who fights for truth, justice, and "all that stuff."

Which brings us to the heart of the matter. Can Netflix create original content for less than licensing it from other creators, that will generate more money than licensed content, in a mass medium model (i.e. not niche content at niche/expensive prices)? Very likely, yes.

TV Networks action/adventure series generally average about $3-4 million dollars per episode. The more action, and the more stunts, obviously the more expensive it is to shoot versus dialog on a soundstage (like ultra-cheap soaps). So on the upper end, excluding tax breaks, it would cost Netflix about $88 million to produce a 22 episode series. Assuming it can sell each episode for about 99 cents or so, its break-even sales volume is about 4 million sales per episode. At about 5 million sales units at that price, Netflix will make about $22 million. Assuming it can build sales to about say, 10 million purchases per episode, it would be generating $132 million per "hit" series, which would be roughly half the views per episode of shows like NCIS (averaging around 20 million viewers per episode per season, excluding repeats). With, critically, revenues rising dramatically as popularity and views per episode go up.

Why was Golden Age Hollywood so mainstream? Because the people who owned it got immediate financial rewards for being mainstream (that's the feedback mechanism of vertically integrated media companies) and punishments for going niche. Warren Buffett's right hand man, Charlie Munger, was quoted as saying:

‘Well I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes [without me] getting some surprise that pushes my limit a little farther.’ That was Charlie Munger, Berkshire Hathaway Vice-Chairman, speaking before the Harvard Law School on the psychology of human misjudgement.

Munger is resolutely focussed on the power of incentives to influence human behaviour. In his speech he recounts a number of examples where incentives have been used for both good and ill. Federal Express was one such example. It has to transport packages within its network to a central location for sorting before sending them on to their final destination. For the system to work, the sorting must be quick and efficient. The trouble was that, for a time at least, it wasn’t. The company tried all sorts of incentives without much success. Then management came up with the idea of paying their staff by the shift, instead of for the shift. In other words, when the sorting was done the staff could go home. As you can guess, along with the staff at the end of their shift, the problem vanished almost immediately.

If not Netflix, then one company not already laden with perverse Hollywood incentives, will push entertainment to a vertical model, where lavish rewards await anyone who can replicate the Golden Age of Metro Goldwyn Mayer, or Warner Brothers. Amazon, Apple's Itunes, Google/Youtube, and perhaps even growth-strapped Microsoft can be players here. Creating their own content, selling it on their own pay/ad-supported network, and collecting hefty profits.

Its far more than a transition from Netflix renting out DVDs through the mail. It is about breaking the stranglehold that Hollywood has had, strangely, in creative content production, for about 90 years. With talent mobile, and lots of money at stake, it is only a matter of time. Particularly as Hollywood's post-80's niche model collapses during hard times.

The return of Louis B. Mayer awaits.
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