Netflix Goes Global, iPhone Worry

Good morning,

It is now 2016, which means this is the last Daily Update of the week. I feel really happy with this week’s posts on augmented versus virtual reality, Twitter, and today’s bit about Netflix. I hope that you feel the same. Tomorrow there will be a new version of Exponent that will cover the recent debate about inequality, and I am happy to report that work has already begun on some new changes to Stratechery that should make it into an even better resource. Stay tuned!

On to the update:

Netflix Goes Global

In a surprise announcement at CES, Netflix announced that the streaming company was dramatically expanding its global footprint to nearly every country on earth. From The New York Times:

Netflix went live with its streaming television service in nearly every country across the world on Wednesday, an unexpected acceleration of the company’s aggressive quest for global ubiquity by the end of 2016…

“Right now, you are witnessing the birth of a global TV network,” Mr. Hastings said from the stage in a keynote address…The proclamation was a bold move from Netflix to address growing skepticism about whether it can sustain its breakneck expansion and deliver on its promises.

Costs are running high for Netflix. In addition to its global rollout, the company plans to spend more than $6 billion in cash on programming in 2016, offering more than 600 hours of original series, films and other content. And after running roughly at break-even profitability through this year, Netflix has pledged to deliver material global profits starting in 2017…Netflix said that in 2016 it planned to release 31 new and returning original series, 24 films and documentaries, 30 original children series and stand-up comedy specials. They will become available to all subscribers at the same time around the world.

First off, while the nature of an Internet service makes it far easier to launch in a new locale than was the case with physical products, it is still incredibly impressive that Netflix pulled off a launch in more than 130 countries with the press of a button. This is by no means the most important takeaway from this announcement — and Netflix has a lot of work to do on language localization for one, and the tuning of price and catalog selection for another — but it speaks well of the company’s ability to execute.

Secondly, Netflix remains the textbook example of what I would call a “ladder-up” strategy:

  • Netflix started by using content that was freely available (DVDs) to offer a benefit — no due dates and a massive selection — that was orthogonal to the established incumbent (Blockbuster). This built up Netflix’s user base, brand recognition, and pocketbook
  • Netflix then leveraged their user base and pocketbook to acquire streaming rights in the service of a model that was, again, orthogonal to incumbents (linear television networks). This expanded Netflix’s user base, transformed their brand, and continued to increase their buying power
  • With an increasingly high-profile brand, large user base, and ever deeper pockets, Netflix moved into original programming that was orthogonal to traditional programming buyers: creators had full control and a guarantee that they could create entire seasons at a time, and, in the beginning, the rights to use what they created elsewhere (more on this is a moment)

Each of these intermediary steps was a necessary prerequisite to everything that followed, culminating in yesterday’s announcement: Netflix can credibly offer a service worth paying for in any country on Earth, thanks to all of the IP it itself owns. This is how a company accomplishes what, at the beginning, may seem impossible: a series of steps from here to there that build on each other. Moreover, it is not only an impressive accomplishment, it is also a powerful moat; whoever wishes to compete has to follow the same time-consuming process.

Third, I found this quote from Peter Kafka’s interview with Reed Hastings in Recode very interesting, particularly in light of my thinking this past year about Aggregation Theory:

Since your last earnings call, some of your big video partners, particularly Time Warner and Fox, have gotten even more explicit about their intent to cut back what they sell to subscription video services. They clearly seem to be talking about you. What’s your response?

We’re going to continue to invest in original content, because that’s something we can influence and control, and consumers love it. So think of that as our big, long-term future. And to the degree that we can continue to license content from them, it’s great for us and great for them. But it’s clearly a decision they have to make.

When did you anticipate you’d see them taking this stance?

I would say very early on, when we were very successful with “Breaking Bad.” Because we knew that while we were adding a lot of value to “Breaking Bad,” AMC had created it. And that in principle, if AMC had a way to monetize the catalog of prior seasons, that would be great for AMC. And they didn’t, so this was the best alternative.

In the long term, the producer/developer was going to be the distributor. We’ve understood that for a long time.

There are a couple of interesting points to unpack here. First off, when Hastings says that the producer/developer is going to be the distributor, he seems to be talking about integrating backwards. This runs counter to a core idea in Aggregation Theory, which is that distributors will aggregate forwards into the customer relationship and in doing so commoditize suppliers. However, as I’ve noted from the beginning, that principle only holds with suppliers that can be, well, commoditized. One thing that makes video such an interesting area to think about is that the content that matters is highly differentiated; by extension, the differentiated part of a value chain can be used as leverage in other parts of the value chain. In the case of Netflix the company is leveraging its control of differentiated IP to build a credible offering to end users in new markets.

In some respects, this actually reminds me of a company that you wouldn’t normally think would be a Netflix comp: Apple. Just as Apple leverages its control of software to sell what would otherwise be a commoditized hardware product at a significant mark up, Netflix is using its control of exclusive IP to sell what would otherwise be a commoditized service (like what happens with music). And, like Apple, Netflix seems poised to succeed in international markets to a much greater extent than its nominal competitors.

All that said, I think that Hastings is selling himself a bit short (given his track record, almost certainly on purpose): the larger Netflix’s user base becomes, the more leverage Netflix will have with content creators. In the case of undifferentiated content, Netflix will simply be too attractive when it comes to spreading out fixed costs; more importantly, in the case of differentiated content that drives subscriptions Netflix will have the biggest pocketbook — they are already spending twice as much as HBO — and given that attention is a zero-sum game, the difference could very well continue to increase.

To be sure, Netflix still has a lot of work to do. The company may have dramatically expanded their theoretical addressable market, but many of the customers in those 130+ countries don’t have reliable broadband connections, much less the discretionary income to spend on Netflix’s programming or necessarily the interest in what has been a western-centric line up. For now the company is launching with the same price everywhere, but I presume that is only temporary: given the fact that video content has high fixed costs but very low marginal costs (basically, the price of bandwidth, which is continually decreasing), it would make sense for Netflix to adjust (i.e. lower) their pricing to a level suitable for each individual market. And, as Hastings noted, without China the company still lacks access to a sixth of the world’s population.

One final note: while most of Netflix’s original shows are available in all 130+ new countries, a notable exception is House of Cards, Netflix’s first original content. Sony actually reserved international rights for House of Cards, which is why it has already been viewed on traditional TV throughout the world, including in China. I am sure that Netflix is bummed about that now, but when it comes to laddering up you take what you can get at the time you can get it.

iPhone Worry

From the Wall Street Journal:

Apple’s plans to scale back sent ripples throughout the multibillion-dollar industry that supplies and builds the company’s phones. A Chinese provincial capital promised Foxconn Technology Group—which assembles iPhones—more than $12 million in subsidies to minimize layoffs at its operations there, according to a government document.

China’s subsidies came after Foxconn began dismissing some workers there earlier than usual for the Chinese Lunar New Year break, according to people familiar with the manufacturer. Component suppliers that rode the iPhone’s boom are now bracing for lower sales. Apple has cut its order forecasts to iPhone suppliers in the past several months, according to three people familiar with the company’s supply chain.

At this point there is getting to be an awfully lot of smoke around the idea that the iPhone is selling below expectations; the big remaining question is just how big those expectations were. For now I will wait until after Apple’s earnings call on January 26th to evaluate whether or not I was wrong when I said to stop doubting the iPhone.

My suspicion is that the company is simply suffering from a tough comparison to last year’s blockbuster. Of course, that is hardly a controversial view: the real question is whether Apple pulled forward upgrades that would have normally happened this year, or whether there is a significant extension in how long people hold on to their old phones. It is a subtle distinction, but it has a big impact on how to think about iPhone growth in the future. Regardless, there is precious little evidence that people are straight up abandoning the iPhone: the real competition is not Android, but rather the iPhones that people already have.

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