Business July/August 2011

Why Content Isn’t King

How Netflix became America’s biggest video service—much to the astonishment of media executives and investors
Taylor Callery

Netflix famously engenders fierce loyalty from its ever-growing customer base. This year, it even beat out reigning champion Apple, among 528 other brands, in Brand Keys’ annual survey of customer loyalty. In more-rarefied circles, however, the company provokes equally intense but quite different emotional reactions. Among traditional-media executives and investors who like to bet on the fall of high-flying stocks, Netflix’s continual share-price appreciation and accelerating subscriber growth have sparked aggravation and even anger. Last December, Time Warner CEO Jeff Bewkes famously likened the relentless march of Netflix to the Albanian army’s trying to “take over the world.” That same month, in a widely read 7,000-word missive, the respected investor Whitney Tilson provided an exhaustive justification for making a huge bet against Netflix, and then had to cover his short position after the stock reached a new high a couple of months later.

Netflix recently announced that with nearly 23 million U.S. users, it is now the largest video service in the country. Most observers expect the company to have more than 30 million subscribers by the end of the year, generating well over $3 billion in annual revenues. Arguments abound about why Netflix should not be as successful and as highly valued as it is. But the animating force of the perceived Netflix Paradox is disbelief that a company that does what Netflix does can thrive amid the wreckage of the media industry. Netflix is primarily in the business of aggregating entertainment content created by other companies and selling access to it as a subscription service to consumers. In a media culture committed to the proposition that “Content is king,” the robust success of a mere redistributor is something incomprehensible and, frankly, a little unnerving, especially while those responsible for the creative lifeblood that flows through its veins struggle for profitability.

In fact, the dirty little secret of the media industry is that content aggregators, not content creators, have long been the overwhelming source of value creation. Well before Netflix was founded in 1997, cable channels that did little more than aggregate old movies, cartoons, or television shows boasted profit margins many times greater than those of the movie studios that had produced the creative content. It is no coincidence that although, say, 90 percent of the public discourse surrounding Comcast’s recent $30 billion acquisition of NBC Universal involved the Conan O’Brien drama or the shifting fortunes of Universal Pictures, in reality, 82 percent of the new company’s profits come in through the cable channels.

The economic structure of the media business is not fundamentally different from that of business in general. The most-prevalent sources of industrial strength are the mutually reinforcing competitive advantages of scale and customer captivity. Content creation simply does not lend itself to either, while aggregation is amenable to both.

Take scale. Because making a blockbuster movie is expensive, people assume that it is a scale business—that is, the bigger you are, the more cheaply you can produce something. But the defining characteristic of scale is high fixed costs that can be spread most efficiently by the largest player. Moviemaking is not this kind of business. The cost of a blockbuster does not vary based on the size of the studio producing it. Creating hit-driven content in any medium does not require significant fixed costs. Some series-based or other kinds of continuously produced content may have a larger fixed-cost component, but they are the exception, not the rule. Aggregation, on the other hand, by its nature requires a large fixed-cost infrastructure to collect, manage, market, and redistribute content. This is why a cable channel with 20 million subscribers loses money but an identical one with 100 million subscribers might have 50 percent margins.

Customer captivity—the “stickiness” of the company-to-consumer relationship—is similar. If Universal had a successful slate of movies last year, customers aren’t more likely to seek out Universal films this year. Again, series or franchise films may be slightly different, but even with that content, the company is much less likely than the talent to be able to reap the benefits of captivity. Just ask the producer at Lionsgate responsible for negotiating with Mad Men mastermind Matthew Weiner, or the Sony executive in charge of enticing Tobey Maguire to make Spider-Man 4, or whoever at Viacom has the unenviable task of discussing new contract terms with the cast of Jersey Shore. Contrast the lack of customer captivity among pure content companies with the leverage cable companies seem to enjoy, by virtue of their loyal viewership, when they threaten to pull their signal from a cable operator.

Presented by

Jonathan A. Knee is an investment banker and the director of the media program at Columbia Business School. He is a co-author of The Curse of the Mogul. Megan McArdle’s column will return next month.

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