If you pushed me, the most “fun” story this week would be the fact that streaming in 2021 finally had a better week than the same time in 2020. But I covered that in my streaming ratings report. Fortunately, when Netflix leaks that they may radically expand their business, that’s easily my story of the week. (And still fun!)
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Most Important Story of the Week – Netflix Is Getting Into Video Games!
One of the most important questions a company has to answer is what to do when you’re successful. Or even wildly successful.
Say you’re a young (25 year old), upstart (industry leader) streaming company. And you find that, due to a once-in-a-century global pandemic, you’re flush with cash. You have about $1.9 billion in cash you weren’t expecting. What do you do with it?
A company with this cash has roughly three options:
- Invest in the future.
- Give the money back to shareholders in terms of dividends or stock buybacks.
- Save the money for a rainy day.
Forget option 3. No one does that. (And once a decade, seemingly, the government has to bail out companies with no savings or cash reserves. Hmm.)
Surprisingly, option 2 is on the table. Last year, after achieving their first full year of positive free cash flow—different from profit mind you!—Reed Hastings speculated openly about returning a dividend to shareholders.
Wall Street, though, doesn’t necessarily love dividends. Some companies have them (Apple) and others don’t (Amazon). Some companies would get crushed if they ended their dividend (AT&T) and others have been rewarded for it (Disney). Really, the question for Reed and company is what investment would drive the stock price higher in the long term: a measly dividend or a potentially game-changing investment in the future. My gut is Wall Street wants to see investment in the future. Netflix is valued like a tech company, so Wall Street wants big ideas for growth.
When I saw this, I said, “Yeah, that’s a big deal.” Let’s explain it and answer whether or not this is a good investment decision.
First, here is what this deal is not.
A lot of folks wrote about this deal—or tweeted at me—something along the lines of “Hey, now Netflix can make Stranger Things video games!” Well, they could do that before. And they did! Entertainment companies rarely have expertise in consumer product production—think apparel, toys, or video games—so licensing content to third parties is usually the most efficient way. And again…
Netflix was already doing this.
They’ve been licensing their IP for consumer products for years. The challenges have been that
- They don’t share ratings data.
- They didn’t own a lot of their IP.
- A lot of initial IP wasn’t very good for licensing, and…
- Some of the kids licensing deals didn’t generate big sales. (Nothing ends future consumer product deals like bad sales!)
Instead, this story is a big deal because it specifically says that Netflix plans to offer video games
Within its own application.
Mainly, this isn’t about video game licensing. Or even video game production. This is about video game distribution. This isn’t just licensing the rights to Netflix’s IP. This isn’t just producing video games itself. This is distributing games within its own streaming video experience. An entirely different ball game.
Does this mean Netflix’s IP is irrelevant to this decision?
Honestly, yeah.
Because licensing IP to make video games is one skill and developing video games is another.
Just take a look at Disney. No one had better IP than them in the 2010s. Scratch that: no one has ever had better IP than Disney for licensing. And yet…Disney doesn’t make their own games. They tried for decades, invested in many companies, acqui-hired and even made their own division. Yet, they now license their games to video game makers and have had some incredible recent success.
If Netflix is to succeed at gaming, it requires being great at either producing or distributing video games. Or both. Bad games with great IP don’t matter.
Why is Netflix getting into gaming?
Let’s say the problem facing Netflix executives at the end of last year really was that they had too much cash. And they know deep down a dividend won’t cut it. That means investing in the business. So figuring out how to use their cash. They’d make a list like this…
- Produce more TV shows and films.
- Get into live sports or news.
- Buy another company for IP.
- Do something crazy, like video games or virtual reality!
Frankly, that’s the list of options facing Netflix executives. This is called “capital budgeting” in business jargon. Meaning if you decide to invest in the future, you rank all your options and, presumably, go with the one with the highest upside. For years, this decision was easy since they just kept making more and more content.
The marginal benefits of more content are decreasing
My gut is that Netflix realized that going beyond one movie a week may not matter to driving growth. Or the costs of films and TV already exceed their benefits. The reason is one of the oldest concepts in economics: marginal benefits.
This is the idea that as you increase the investment into a given product or venture, the returns decrease over time. In this case, the 200th film is less valuable than the 20th film at keeping customers returning.
So you have to look somewhere else. They’ve already conquered film and TV. Now they need to conquer something else.
Netflix won’t make live TV because they are “Never-Flix”
One of my favorite nicknames for Netflix I coined a few years back. “Neverflix”. As in…
We will never carry live sports.
We will never offer live streaming TV.
We will never release weekly.
We will never have advertising.
By live content, I mean TV that is just streaming. You know, like the wildly popular FASTs, like Pluto TV. Or Twitch live streams. Or just cable. It turns out that this type of content has a role in many folks’ TV diet. Yet, Neverflix has never invested in live streaming. It just isn’t in their brand.
Plus, it’s expensive. Especially sports. If you want the upside of sports, you have to shell out the bucks. Netflix may have had a few billion lying around, but not enough to buy NFL rights. Especially on a global basis. If Netflix did, they’d be cash flow negative again, and Wall Street may not like that.
So two potential options are out for Netflix.
M&A is probably too expensive too
While Netflix may feel like they have a few billion to allocate towards video games, that doesn’t mean they have unlimited cash to spend. Netflix will still end 2021 either with breakeven free cash flow, slightly positive, or slightly negative. Within a billion dollars either way. Meaning if Netflix wanted to buy someone, they’d have to do it with all stock or take on debt or both.
But all of that requires tricky financial engineering and explanations to Wall Street. (And maybe the FTC/FCC.) If they invest several hundred million dollars or billions into video games, they don’t have to go through the hassle of buying someone or explaining to Wall Street the shareholder dilution. Not to mention, a “game-changing” merger probably doesn’t come for less than $15 billion, which is a much larger figure than we’re talking about here.
So options one to three are out.
Video games are a new growth area.
Mainly because they don’t require advertising and don’t violate any of their other “nevers”. In other words, this is the only option (or say one of two options with VR) to expand the Netflix content footprint without violating their core tenets.
Look at it this way. If their engineering teams are good enough to make video games work seamlessly, then they get a ton of new content options while leveraging the benefits of their UX and installed subscriber base. (I’d put AR/VR into this same category: if you plan to make Netflix “VR applications” for VR headsets anyways, why not look into VR as a category?)
But it isn’t all sunshine and roses.
Video games also create their own problems.
My biggest concerns are the unknowns: what does this look like in practice?
Is the goal for the games to be played on mobile devices? On living room TVs? With handheld controllers? Remotes? Will the same game work on the Windows desktop and a Roku box and an Apple iPad? What about cable integrations like Comcast? Or globally on mobile devices with low bandwidth? Or will Netflix need a new application entirely?
So many questions!
Worse, the history of pivots to “video games” aren’t great. I already mentioned Disney above but would add Google and Amazon to the list. Google recently ended its live streaming video game effort called Stadia in February. Amazon has been routinely mocked for how poor its games are. Which means that Netflix thinks they can succeed where three other giants have failed.
Most of those ventures failed because the expertise in one arena (search, cloud computing/retail and IP) didn’t translate to video game success. In other words, Netflix’s core competencies (UX and content algorithms) don’t scream “video games”.
And Netflix has way less cash flow than Google, Disney or Apple.
Moreover, the upside is definitely constrained if the games have to stay inside the Netflix application. Most successful video game ecosystems work by allowing third parties to monetize via the ecosystem. Think the Apple App Store, Steam’s Valve, or Xbox and PlayStation stores. Those work because third parties compete to sell their games. Netflix won’t have that advantage here. And if Netflix does make a standalone application, well now it has to compete in a wildly competitive marketplace.
Conclusion: Is streaming a good business?
Here’s the most pessimistic reading of Netflix’s big new announcement. Say the more conservative “bass diffusion” models are right for Netflix’s future subscriber growth. Meaning Netflix is closer to 300 million global subscribers than 500 million. And with that stall in growth, revenue will stop growing. Worse, let’s say that streaming long term looks more like traditional entertainment revenues/profit/cash flows. That implies Netflix’s future price-to-earnings ratio is more around 15-20 than its eye-popping 64 of current times.
In other words, streaming on its own may not be a great business. Diversify for growth, or the stock price pays the price.
Competing in streaming will be tough; they don’t call it a war for nothing. Competing in streaming and video games will be even tougher. But it’s a bold call by Netflix.
(I’ll finish with a link to this coverage of Bernstein’s analysis by Todd Juenger, which has a good rundown of pros and cons too.)
Almost Most Important Story of the Week – Everyone Is Up For Sale
Together, these three stories make a heckuva coincidence:
Each of these production companies/studios has really benefited from the streaming boom of the last few years. Take A24 in particular. Early on, they signed a Pay-1 film deal with Prime Video that essentially covered their production costs. Then, since Apple needed content, they got an even better deal for their films. Meanwhile, their biggest hit is essentially Hereditary, a $80M million grosser.
Given that MGM set the bar at $9 billion for an IP library, essentially the entire market is frothing. Boiling. Dare I say…bubbling? Because on a cash flow basis, none of these valuations make sense. But that also explains why this stream of headlines is out there: if a market is a bubble, the goal is to get out before it pops.
Update To An Old Story – Universal Sells Off The Rest of Their Windows
Last week, I told you that Universal’s decision to split the baby (its film streaming windows) didn’t make sense to me. Well, with these headlines…
…Universal has sold off nearly every other window. That baby got cut into many, many pieces. (Okay, no more with the baby analogy.)
There is one big word that I think shows Universal’s shortsightedness here:
“Exclusive”
If each of these films were licensed non-exclusively, I’d probably like and maybe love Universal’s strategy. They’d still have Peacock as the one-stop library for every Universal film. But they’d be making money and building awareness on other platforms. But that isn’t what they’re doing, because exclusivity is worth a higher price. So they sold all the rights. And my points from last week stand.
To add one more detail, though, you do have to wonder if this indicates a negative prognosis for Universal’s 2020 film slate. Two pillars (Fast and Furious, Jurassic World) are each ending. The Monster-verse never took off. And maybe they are pessimistic about animation. In other words, is Universal getting out while the getting out is good?
M&A Updates – Two Media Companies Go Public Via Spac
Both Buzzfeed and Vice are leveraging the SPAC boom to go public. Overall, I’d say this is a “meh” sign for media’s future. While both companies feel they’re doing well enough to go public, at least some of this has to be the investors seeking an exit while an easy (SPAC) option is out there.
Other Contenders for Most Important Story
Netflix is Making Podcasts Too!
Take everything I wrote above about video games and apply it to podcasts. Netflix hired a new head of podcasts, though I’m much more skeptical this leads to actual podcast distribution than simply expanding original content based on their IP.
The Magnolia Network Launches (on Discovery+)
Over on Discovery+, the Magnolia “network” is launching, with plans to launch a cable channel later this year. It’s not often you see a full-fledged launch of a new digital product and a future cable channel next year.
Lots of News With No News
SoHo House is Going Public
The SoHo House is an LA institution for the entertainment elite of New York and Los Angeles. And now this exclusive club is going public, with an eye to expansion. (On launch, the IPO failed to “pop” and was down 10% on the first day of trading.)
The Emmys
Yes, the Emmys are a big deal for the talent who is nominated for and wins the awards. Does the horse race coverage of how many nominations each studio garnered matter? Not really. Frankly, I’m glad that, with streaming ratings, the metric for success in streaming is moving away from these awards shows.
