While much of the focus of last Thursday’s Apple announcement was on the new MacBook Pros (and the Macs that were not updated), the more interesting announcement from a strategic perspective was about Apple TV. Tim Cook stated Apple’s goals plainly:
We want Apple TV to be the one place to access all of your television. A unified TV experience. That’s one place to access all of your TV shows and movies. One place to discover great new content to watch. So today we’re announcing a new app and we simply call it ‘TV’…
After the app demo, Cook concluded:
Apple TV, iPhone and iPad have become the primary ways that many of us enjoy watching television, and now with the TV app there’s really no reason to watch TV anywhere else.
Unless, of course, you want to watch Netflix.
Apple’s Leverage Playbook
- Back in 2006 Apple sought to release the original iPhone on Verizon; the leading carrier in the U.S., though, was wary of Apple’s demands that there be no Verizon branding, no Verizon control of the user experience, and no Verizon relationship with iPhone users beyond managing their data plan. Therefore, Apple launched the iPhone on the second-place carrier (AT&T née Cingular); AT&T accepted Apple’s demands in full with the hope that Apple’s famously loyal customers would see the iPhone as a reason to switch.
- That, of course, is exactly what happened: in the five years following the iPhone launch, AT&T went from trailing Verizon by $400 million in wireless revenue to leading by $700 million; that’s a $1.1 billion switch thanks in large part to Apple loyalists’ willingness to switch carriers to get an iPhone. The effect was even greater on smaller carriers, which had no choice but to accede to Apple’s increasingly demanding terms: not only would Apple own the customers, but carriers had to agree to significant marketing outlays and guaranteed sales to carry the iPhone.1
- Apple repeated this formula in market after market: in Japan, for example, Softbank leveraged the iPhone to huge increases in market share, forcing NTT Docomo to finally give in to Apple’s terms. Apple’s leverage also played a role in bringing China Mobile to the negotiating table, along with Apple’s ability to drive higher average selling prices for China Mobile’s then new 4G network.
The iPhone wasn’t the first time Apple used this approach: perhaps the most famous example of Apple coming to dominate its suppliers was the iPod and iTunes Music Store, when Apple was able to leverage its loyal users to dictate terms to the music industry. In some respects this was the more impressive achievement, because while carriers are largely undifferentiated (presuming you live in a location with comparable coverage), music labels have exclusive rights to huge catalogs of music. This should, in theory, provide strong leverage in negotiations, but especially when the iTunes Music Store got started, the labels were terrified of the effect music piracy was having on their business. Apple offered a better alternative to piracy, and then grew so big the labels couldn’t afford to not have their music on the iTunes Music Store.
The problem Apple has in premium video — and given that the company has been trying and failing to secure video content on its terms for years now, it definitely has a problem — is that its executives seem to have forgotten just how important the piracy leverage was to the iTunes Music Store’s success. This Wall Street Journal story from this past summer is one of many similar stories over the years detailing Apple’s take-it-or-leave-it approach to premium video content:
[Senior Vice President of Internet Software and Services Eddy] Cue is also known for a hard-nosed negotiating style. One cable-industry executive sums up Mr. Cue’s strategy as saying: “We’re Apple”…TV-channel owners “kept looking at the Apple guys like: ‘Do you have any idea how this industry works?’” one former Time Warner Cable executive says…Mr. Cue has said the TV industry overly complicated talks. “Time is on my side,” he has told some media executives.
Time may be on Apple’s side, but the bigger issue for Cue and Apple is that leverage is not; that belongs to the company that is actually threatening premium content makers: Netflix. Netflix is the “piracy” of video content, but unfortunately for Apple they are a real company capable of using the leverage they have acquired.
Much like Apple vis-à-vis the music industry in the 2000s, Netflix got its start by being a friend to the industry it would eventually threaten: DVD sales simply added to the premium video industry’s bottom line, and when the company made the leap to streaming it was through a deal with Starz that the latter basically viewed as found money. Streaming, though, was transformative to the user experience: while Starz had an 11,000 movie catalog, the effective catalog size was one — whatever was showing on the Starz linear TV channel. On Netflix, though, the effective size of the catalog was 11,000: Netflix customers could watch whichever movie they wished whenever they wished on any device they wished.
That superior user experience drove Netflix’s ever-expanding user base, which gave the company the capability to acquire more content with money that was still pure profit for network owners; by the time said networks woke up to the fact that Netflix was devouring attention they were, like the music industry relative to Apple in the 2000s, increasingly captive to what was one of their biggest buyers. Netflix, meanwhile, was investing in its own original content, making deals with content creators directly; this strengthened Netflix’s value proposition to customers, further weakened the negotiating power of networks, and laid the groundwork for Netflix to leverage the Internet to offer its service to nearly every customer on Earth.
Netflix’s strategy has been a textbook example of Aggregation Theory; Netflix has built leverage and monopsony power over the premium video industry not by controlling distribution, at least not at the beginning, but by delivering a superior customer experience that creates a virtuous cycle: Netflix earns the users, which increases its power over suppliers, which brings in more users, which increases its power even more.
It is this virtuous cycle that drives Netflix’s $54 billion valuation, which implies a sky-high price-to-earnings ratio of 340; the company is spending billions on an ever increasing amount of original content that threatens to cut out networks entirely, leading Hollywood to fear a content monopoly. The big question is if Netflix has the financial firepower to pull it off: the company had -$506 million in free cash flow last quarter thanks to its ongoing shift from licensing original content (which is pay on delivery) to self-producting it (which requires investment months or years before the content is actually available); this shift gives Netflix even more leverage — and cuts out traditional networks even more — but it’s expensive, and the company has to keep raising debt on the assumption subscriber numbers will increase enough to pay for it.
There were mixed reports as to why Netflix is not in Apple’s new ‘TV’ app: Peter Kafka reported that Netflix was out even before Apple’s event, while Netflix told Wired that the streaming service is “evaluating the opportunity.”
In fact, though, I suspect those reports aren’t so different after all: Apple’s desire to be “the one place to access all of your television” implies the demotion of Netflix to just another content provider, right alongside its rival HBO and the far more desperate networks who lack any sort of customer relationship at all. It is directly counter to the strategy that has gotten Netflix this far — owning the customer relationship by delivering a superior customer experience — and while Apple may wish to pursue the same strategy, the company has no leverage to do so. Not only is the Apple TV just another black box that connects to your TV (that is also the most expensive), it also, conveniently for Netflix, has a (relatively) open app platform: Netflix can deliver their content on their terms on Apple’s hardware, and there isn’t much Apple can do about it.2
The truth is that Apple’s executives seem stuck in the iPod/iTunes era, where selling 70% of all music players led to leverage over the music labels; with streaming content is available on any device at any time, which means that selling hardware isn’t a point of leverage. If Apple wants its usual ownership of end users it needs to buy its way in, and that means buying Netflix.
Why Apple Should Buy Netflix
I am, as a rule, skeptical of large acquisitions: they are all too often a byproduct of management empire-building, and value-destructive for shareholders. Moreover, not only do promised synergies often fail to materialize, but both the acquirer and the acquired are deeply distracted for years.
I am even more dubious when an acquisition entails combining horizontal and vertical business models:3 horizontal business models, like Netflix’s, entail reaching the maximum number of customers across all devices in order to better leverage up-front costs; vertical business models, like Apple’s, entail offering exclusive services to increase the differentiation of devices sold at a profit.
So why am I advocating an acquisition that is both large and entails combining two orthogonal business models? Surprisingly, I think the argument for Apple is more compelling:
- As I argued earlier this year, the iPhone was the pinnacle of the product business model: it leveraged software to sell an incredible number of highly differentiated physical devices with a fabulous profit margin (in both percentage and absolute terms), but the future of high-dollar physical goods is to be offered as a service. I strongly suspect this reality was an important reason for Apple’s reset of the Apple Car project.
- In an ideal world one could argue that Apple should change its employees’ compensation mix to more strongly favor high salaries over stock, dramatically increase its dividend program, and gracefully ride its hardware business model as long as it could; here on planet Earth Apple needs a growth engine to replace the iPhone, if not in reality than at least in potential.
- Apple is at its best when it is creating new products that are the best they can possibly be; it is a capability that is rather independent from Apple’s biggest strategic assets: its dedicated user base and massive cash pile.
A Netflix acquisition would:
- Give Apple one of the strongest entrants when it comes to business models of the future
- Provide a far more compelling growth narrative than its current hardware business (particularly given the advantages Apple gives Netflix, which I will discuss below)
- Leverages Apple’s assets in a way that leaves the product company free to focus on what it does best
The payoff for Netflix is more straightforward:
- As I noted above, Netflix’s valuation is already sky-high, with a stock so volatile that CEO Reed Hastings felt compelled to apologize to investors on Netflix’s recent earnings calls. The issue is that Netflix’s potential is massive for all the reasons I described above, but realizing that potential entails spending money the company hopes to gain from future subscribers. Ergo, any surprises in churn or new user numbers send the stock on a roller coaster. Having Apple’s financial backing will alleviate those concerns.
- Apple’s bank account will also allow Netflix to accelerate its strategy of complete ownership of original content. As I hinted at above, most original Netflix content to date has been licensed, not owned, which is problematic in two ways: first, Netflix faces some restrictions on said content, whether it be a temporal license or a geographic one. Secondly, Netflix isn’t realizing the full profit from its original content, in perpetuity; given Netflix’s business model is so powerful precisely because content is valuable not only when it is shown the first time but every time thereafter, this is an unfortunate giveaway dictated by Netflix’s meager cash position. With Apple behind it Netflix could pursue the same strategy it used for this summer’s Stranger Things: produce content without any middle men, and reap the proceeds — and leverage the freedom — forever.
- While Apple should keep Netflix cross-platform (limiting Netflix to Apple devices would be massively value destructive — Netflix’s value is predicated on being everywhere — and not even that helpful given that Apple’s devices already dominate their price points), that doesn’t mean that making Netflix available by default on every Apple device wouldn’t have the potential to drive Netflix subscriptions. This could be especially effective internationally where Apple’s brand is much stronger than Netflix’s.
Make no mistake, this would be a massive deal: Apple would probably need to pay a 20% premium at a minimum, which means an acquisition price north of $65 billion (and I’d bet higher). And yet, the biggest reason I’m skeptical it will happen is that I’m not sure Netflix would say yes: the company has made it this far with a ladder up strategy predicated on delivering a superior customer experience, and provided the company can keep the cash flowing the leverage in video is all theirs. Granted, Amazon Prime Video is a big threat, particularly because their orthogonal business model and big company backing give them the ability to match Netflix dollar-for-dollar when it comes to acquiring content, but having made it thus far, does Hastings want to take the easy way now?
As for Apple, Cook has been resolute in following the Steve Jobs playbook, which would seem to rule out a transformative acquisition of this nature. Still, strains are showing: in retrospect the Apple Watch was rushed to market, the company is raising prices to preserve margins and average selling prices, while the company seems to be cutting costs on the margins. Wouldn’t it be a relief to sell a future based on more than squeezing the last drops of blood out of the iPhone rock? Indeed, the iPhone as cash cow and Netflix — run as an independent subsidiary — as growth driver would arguably create the greatest possible freedom to recreate the future once again.
As I’ve noted several times in the Daily Update, these contracts gave Apple remarkable precision in forecasting iPhone growth; that the iPhone is mostly everywhere now is, I suspect, a reason why Apple’s forecasting has been off (in both directions) for the last several quarters ↩
In theory Apple could mandate that all streaming apps tie in to the TV app, but I think the company would soon find that Netflix could drive the sale of other streaming devices more easily than Apple can drive the surrender of Netflix’s most important strategic advantage ↩