Netflix’s Moats

The dictionary definition of a 'Moat' is "a deep, wide ditch surrounding a castle, a fort, or a town, typically filled with water and intended as a defense against the attack."

Over the past few decades, investing community has borrowed this word to define a business' ability to sustain advantage in the face of competition and earn long-term profits.

I've written a few posts in the past talking about the consolidation happening in the media industry and Netflix's user experience advantage over Amazon Prime. Since then, there has been a lot of changes in the media landscape. But, what has remained constant is the continuous growth of both Netflix's user base and the mindshare it has captured in the industry.

In the last few months, Disney has completed the acquisition of Twenty-First Century Fox, and AT&T won the case against Trump administration and completed the acquisition of Time Warner. Now, both are working on launching their own direct-to-customer SVOD (Subscription Video On Demand) services to challenge Netflix. In fact, Disney just announced the launch of its service towards the end of 2019.

Netflix has remained unchallenged for a long time as it built a direct-to-consumer service over the Internet, whereas the existing TV networks reached out to customers through cable companies and didn't own the customer relationship. Also, these TV networks fed into Netflix's success by licensing their content to Netflix to earn additional income. But, does the future of Netflix looks cloudy in the face of formidable competition that is shaping up on the horizon:

• Will the user growth stagnate?
• What will be the impact on customer acquisition costs?
• Will it reduce Netflix's pricing power over the customers?
• Will Netflix ever be able to turn cash flow positive if it has to increase content investments further?
• How will Netflix pay back such a huge debt it has taken to create/acquire content?
• How significantly will the catalog of Netflix shrink once competition launches their own SVOD and pull their content away from Netflix?
• And so many other questions….

To answer these questions, we need to understand how wide Netflix's Moats are and how much of a sustainable advantage do these moats give to Netflix.

But, before that, we need to understand why these companies are coming up with their own direct-to-consumer SVOD services now after licensing their IP to Netflix for more than a decade.

The reason is the structural changes happening in the linear TV industry. Currently, these media companies generate revenue from 1) affiliate fees per subscriber they get from cable companies who are responsible for distributing TV to the end consumers 2) brand advertising spend from big conglomerates 3) licensing content to other networks including Netflix.

Because of the Internet, people are spending more and more of their free time on other sources of entertainment. On the one hand, the younger generations aren't signing up for linear TV bundle, on the other, the older generations are also cutting the expensive cords and using the Internet to consume content. Therefore, affiliate fees revenue for these TV networks is declining, and the acceleration has accelerated significantly.

The advertising business of these networks is also at risk as the companies that spend the most on TV advertising are themselves experiencing a secular decline. Companies from CPG to big-box retailers to automobiles, all big spenders on TV advertising, are getting disrupted by Internet or other technological changes. This post by Ben Thompson beautifully explains the phenomenon in detail and worth the read.

Therefore, in the face of existential threat looming large over their head, these companies are changing their business model by launching their own direct-to-consumer offerings, and this will compete directly with Netflix.

Disney is going to launch its service with the combined strength of both Disney and Fox IP and is now a majority stakeholder in Hulu too. ATT has acquired Time Warner and plans to create a direct-to-customer SVOD service around its most prized asset, HBO. Comcast bought Sky TV last year which has a significant presence in European markets and is working on its own service too by leveraging NBCUniversal assets.

So, what are the chances of Netflix's success when such formidable competition is knocking on the door, and that too a competition on whose IP, Netflix has built a business with 150 million subscribers across the world?

Will the direct-to-consumer offerings from these companies be able to reach the scale Netflix has reached? Will Netflix remain relevant in the face of this new competition? To answer these questions, we need to study Netflix's moats and understand how these moats came about.

Switching Costs

Have you ever thought about canceling Netflix or switch to a different streaming service? If yes, is the reason, because you're not getting enough value out of it? I've thought about it multiple times. But the reason is never the value I get out of my money. Every single time it is is the guilt trip I go on after wasting too many hours binge-watching.

Switching costs are a measure of how difficult it is for you to move from the product to its competitors. The higher the switching costs, the wider the moat is for the company delivering that product. A well-known example of a product with significantly high switching costs is an ERP system in a large enterprise. It is kind of a virtual brain of the enterprise and requires massive multi-year and expensive effort to switch to another vendor.

Switching costs aren't very high in the case of most of the consumer products. In the case of Netflix, all it takes is a single press of a button to cancel the service and sign up for another provider if you want.

But what do you stand to lose by canceling your Netflix account and switching to another provider?

Netflix not only has original programming that you cannot watch anywhere but also has thousands of other licensed titles in the catalog. And you can view all of it with plans ranging from $8/mo - $14/mo. For most markets, from a value perspective, that's a steal. A combination of original programming that you cannot watch anywhere except Netflix and no other low-cost alternatives for such vast content library prevents users from canceling or choosing another service over Netflix.

Netflix catalog has shrunk significantly over the past few years as these TV Networks have stopped renewing some of their licensing deals with Netflix as they gear to launch their own service and now see Netflix as more of a threat. The catalog is going to shrink even further once these networks launch their SVOD services. Does it mean that the value of Netflix as a service decline significantly, and thus, the switching costs?

If the same question were asked 3-4 years back, the answer would have been a definite YES. But Netflix has spent HUGE amounts over the past 5 years to produce original programming and is going to invest significantly higher than that over the coming years. According to some analysts, Netflix content budget for 2020 might hit $20 billion. From a comparison perspective, HBO budget for 2020 is going to be in the range of $2-$3 billion. Its budget is going to be significantly higher than that of all of its competitors, including the combined strength of Disney + Fox (if you only take into account non-sports programming). And a significant part of that budget will go towards original programming that would make Netflix's service more stickier as you won't get the content anywhere else except Netflix.

Furthermore, the SVOD services from these competing networks are still taking shape, and even after launch will take years to reach the scale where they are a threat to Netflix when a significant number of users choose them over Netflix.

Therefore, in my opinion, it might hurt Netflix once some of the top-notch content goes away after the licensing deal expires (Disney will forgo ~$350 million in revenue from Netflix by removing all its content including Marvel, Pixar, and Star Wars). But most of the most-watched licensed content on Netflix isn’t going away anytime soon. Therefore, I think Netflix will do fine, as, by the time that happens, there will still be so much great content to watch on Netflix that not many customers will consider switching.

There is another vector to look at when understanding switching costs. In the case of linear TV programming, you can easily switch between TV channels through a remote to discover content that's coming on each channel. But in the case of SVOD, first of all, there is significant friction in switching between multiple apps. Second, the onus is on the viewer to find something to watch rather than view something that already on the TV schedule.

Not only will Netflix have a significantly higher content than other services (making the decision of just sticking to Netflix app for watching content) but also Netflix has invested a lot in discovery/search and personalization of content making it easier to help users find (as fast as possible) what they'd like to watch. These reasons will collectively help Netflix in becoming the default go-to-app and puts it in the best position to become a replacement of linear TV when that happens.

And when it becomes your default go-to-app TV for watching content, will you consider an invoice from Netflix as more of a water/gas bill or some discretionary spend at a dinner at a restaurant? Eating outside is one of the top items on your list when you're looking to cut your discretionary spending. But, do you ever think about removing your water/gas connection or moving to a different provider?

I'm betting my money that Netflix will fall under the utility bill bucket (mostly applicable for the English content audience right now, but it's going to change as Netflix gets more local content on the platform and also explores other business models to make its service ubiquitous across the world). And most of the consumer will consider the invoice from Netflix a default for their monthly budget.

Therefore, it's highly unlikely for other services to replace Netflix soon.

Network Effects

A product having network effects mean that the addition of each user increases the value of the product for the existing users on the product, which in turn attracts even more users, and more users further increase the value of the product. The flywheel continues as more and more users get attracted to the platform. The stronger the network effects are for the company, the wider the moat it is for the competition to breach.

Is there any kind of network effects at play on Netflix? And, if so, how strong are those?

I see multiple network effects going on in Netflix's business.

Subscriber - Content Flywheel

Netflix makes money by charging subscribers a monthly fee to watch the content on its platform. Acquisition of each new subscriber brings in additional revenue for Netflix. Netflix uses this additional revenue to invest in producing/licensing more content. Increase in the content makes Netflix more valuable for the users and, therefore, attracts more new users and makes the existing ones more sticky. More users bring in more revenue, which again generates more content.

Network effects of similar nature exist in current TV networks too but are a lot weaker for multiple reasons 1) They don't own the customer relationship and thus don't have 100% control over the affiliate fee from subscribers 2) TV runs on a linear schedule, therefore, at any point in time, only one piece of the catalog can be watched. It doesn't matter how big of a catalog you own. Whereas, on Netflix, you can watch anything at any time without any bounds of a fixed schedule. Therefore, the value of these TV networks doesn't increase significantly as more content gets added to the platform.

Subscriber - Content Creator Flywheel

The signup of more and more users on the platform makes it easier for Netflix to convince both content producers and talent to sign exclusive deals with Netflix, which increases the supply of exclusive original content on the platform. Exclusive content again attracts more users, which in turn attracts more suppliers and thus the leverage of Netflix. Who could have thought that Shonda Rhimes from Disney and Ryan Murphy from FX will sign multi-year exclusive deals with Netflix running into hundreds of millions of dollars when Netflix first launched the original content.

Date Network Effects Flywheel

As more and more content comes to Netflix and gets watched by more and more users, Netflix gets better at understanding the tastes that appeal to each segment of users. Bird Box is the recent good example where Netflix combined the horror niche with the star power of Sandra Bullock to make a blockbuster hit.

It not only aids Netflix in producing the content that its audience wants but that too at a significantly lower risk than existing networks. According to this article, only 2% of the scripts that a traditional TV network buys have a chance of achieving commercial success. I don't have any insights into the success rate for Netflix, but my hunch says that it is going to be significantly higher for Netflix.

The higher rate of commercial success brings down the costs of content production for Netflix, which gives Netflix the optionality to keep charging less and pass those savings to its customers. Low subscription costs further attract more users, and these users provide more data to help Netflix understand the tastes and make the content selection and production more efficient.

Barriers to Entry/Economies of Scale

The cost structure of Netflix's business model demands HUGE upfront fixed investments - both to produce/license content and to build & support the technological infrastructure to stream the content to its hundreds of millions of users across almost every country in the world. The variable costs - costs to serve the same content to each additional customer - is infinitesimally small.

Content

The content library and thus the content acquisition costs increases as more and more users join the platform, but that's accounted for as a fixed cost which Netflix has to commit to for the growth of the platform.

These fixed costs, running into billions of dollars, make it extremely difficult for most of the competition even to consider entering into the market. Even companies at the scale of Apple and Google aren't ready to commit significant investments to compete. Google is dragging back its feet on its strategy to produce original content, whereas Apple has committed to only a small amount to create exclusive content.

Even if the competition is willing to commit billions of dollars to compete, it going to take them years for the economics/ROI on content acquisition to be as favorable as it is for Netflix.

Their cost of production/licensing of content isn't going to be significantly lower than Netflix (unless you're riding on a powerful existing IP, i.e., Disney). And Netflix will amortize those costs over a significantly higher user base (150+mm) vs. a minuscule base of the new competitor. Therefore, Netflix will be willing to pay higher than the competition to outbid them and still make the economics work.

Technology

From the technology perspective also, the large user base of Netflix helps it amortize the fixed costs of technology development and thus rationalize the spend. Whereas, the competition will have to commit to billions of dollars in investment to build the kind of technology streaming stack that Netflix has developed over the last decade to provide a matching ubiquitous and seamless viewing experience. And still, hope that they will be to reach the scale of Netflix. More details on the technology moats are covered towards the end of the article.

International

Netflix's ability to launch its original content across all the 190 countries at the same time is another significant moat. Current cable and broadcasting networks can't do so because of the myriads of international licensing deals from the past that will take years to expire. Even for new content, it requires collaboration with distributors (cable operators) all across the world, which is kind of impossible.

The new SVOD services announced by these networks have a long journey ahead of them to achieve that feat. As doing so would require them to 1) get the rights back after the licensing deals expire  2) build the technology to make it possible to launch content in all international markets with a simple push of a button 3) build the technology to make the viewing experience seamless and magical everywhere 4) create a big enough pipeline of new original content for customers to even consider subscription of their service.

According to this article by Matthew Ball, a former head of Strategy at Amazon Studios,  the recently announced Disney+ service scheduled for launch in Nov'19 will be available only in select international markets (and many will have further rights limitations), Warner Media's SVOD service will launch in 2020 and the original content will start coming to the service only in late 2020. It hasn't announced international plans yet. Even if the international plans are announced soon, the core of the service is HBO and HBO is stuck in many international licensing deals for years to come, and that won't make its content exclusive to the SVOD service to gain significant subscribers. Similarly, Hulu doesn't have rights to many of its branded originals outside of US.

In conclusion, it will take years for the competition to bring all the pieces together to achieve the scale of Netflix and be competitive. And, I'm betting that by the time that happens, the invoice from Netflix will become more of a utility bill that would be given for your monthly budget.

Technology and Product

Unlike other media companies where technology plays more of a supportive role and is subordinate to the content, Netflix is a technology-first company; For Netflix, technology is as integral as the content. It invests a significant $’s in technology R&D that makes it possible for its users to watch content in any corner of the world without interruptions.

Streaming Technology

Netflix has been working on perfecting its streaming tech ever since it launched the service in 2007. And in the process has developed a significant amount of IP in encoding technology that provides the best possible streaming experience while using the lowest amount of bandwidth. Try downloading a video for offline viewing on both Netflix and Amazon Prime to and you'll notice how fast the download happens on Netflix. This post by Netflix throws some light on their latest encoding framework, Dynamic Optimizer, launched last year that shrinks the bandwidth requirements significantly while maintaining almost the same quality. The only competing tech that can somewhat match Netflix's capabilities is by BAMTech (Disney has a majority stake in the company).

Distribution

In 2012 itself, Netflix was supported on 800+ devices. It should be significantly higher now. Netflix has architectured its platform in a way that allows its distributed UI teams (responsible for supporting each of these devices) to develop device-specific APIs that serve the needs best for the customers streaming on that specific device. It has taken them more than a decade to be ubiquitous and provide the best possible service on each platform.

Netflix has also invested significantly to build its own CDN (Content Delivery Network), Open Connect, that is highly optimized to deliver large-size files. By partnering with ISPs across the world, Netflix has placed these CDN servers across the globe at ISP premises to put the content as close to the user as possible. Also, the intelligence logic built within the Netflix client app helps it dynamically pick the CDN that gives the best performance while viewing.

Automation of Production and Post Production work

Netflix is also leveraging technology to try and bring significant efficiencies in both the production and post-production work required to create and launch content.

For content production, it's creating tools that help streamline the production processes, i.e., crew management, scheduling, etc.

For post-production work, it's using computer vision and machine learning in multiple areas: extracting frames from the videos to generate artwork for each title, generation of trailers for the videos algorithmically, localization of content by creating audio and subtitles in local languages, automated generation of collateral to be used for promotions and customer acquisitions.

Building capabilities in these areas creates significant leverage for Netflix by removing significant inefficiencies around the value chain of content creation and promotion. Even if old media companies build similar technologies, it will be difficult for old media companies to alter their value chains overnight.

Personalization at Scale

In this post from the past, I've covered how Netflix, unlike any other streaming service, personalizes the experience for each user by significantly leveraging computer vision, machine learning, and tagging each piece of content into one or more of the 80,000 micro-genres and matching those to each person's viewing habits. The goal is to create an experience that is unique to each user and thus increase engagement and stickiness of the user on the platform. Netflix is also experimenting with interactive content that even personalizes the content/storyline itself to the tastes of the viewers.

Data Collection and Insights

Last but not least, Netflix has built the data infrastructure that helps it record each and every activity taking on the platform amounting to billions of events each day and analyze those to generate meaningful insights. Building data infrastructure at such scale is no easy feat, especially for companies that aren't as tech native as Netflix is.

In conclusion, all of these factors, when combined together, create a formidable moat for Netflix in that won't be easy for its competitors to breach. And, thus, Netflix is going to remain a force to reckon with and will have a significant impact on the media and entertainment landscape for the foreseeable future.

That's all I had to say. I haven't touched upon Netflix's culture and how significant a moat that is. I haven't read enough to make any judgments about that but plan to read the book on Netflix, Powerful by Patty McCord, who helped create the culture at Netflix. If you think there is more to Netflix's moats that I haven't covered, please leave those in comments. Thanks for reading!!

Thanks Suman and Rajiv for reading the drafts and suggesting edits.