Netflix – Content Distributor Going Into Gaming [SGO 17]
Following its latest success Squid Game, Netflix has reiterated its ability to use data and consumer trends to milk our attention. With the largest distributor of content in the world entering the gaming space, how far can this company go?
Explore Netflix’s business model in this week’s Stock Geekout episode and make the judgment for yourself.
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Reggie: Today in TFC Stock Geekout, we’re going to explore the largest distributor of content in the world, period. They are the largest and following their latest success Squid Game, I think it reiterates their ability to use data and understand consumer trends to keep milking our attention. With their latest higher commitment to enter the gaming space, we have to wonder how far can this company go? I think it does not require much introduction as a consumer. We have consumed our content, interacted with their platform, but today we’re going to focus on the business model and how its growth will look going forward.
Expand Full Transcript
So joining me today to geek out on this content giant Netflix, is Ser Jing from the Good Investor and compounderfund.com. He strongly believes in Netflix and has a lot to say about their endeavour into gaming. At the core, we have to recognize that Netflix is a distributor and it has very strong pricing power. It just increased its pricing power recently, but can it stay dominant and keep growing? That’s the question.
For your reference sake, this episode was recorded on the 28th of July, 2021. Our discussion today is solely for education and entertainment purposes only. It does not serve as any form of advice or recommendations. Thank you for loving what we do and supporting us financially to do more for you. Join our Telegram to further discuss. Let’s geek out!
So yes, we back live today. Me and Ser Jing, we’re going to record and talk about Netflix as a company. I think there’s a lot of interesting stuff going on with Netflix, but more importantly, I think as a consumer and as an investor, there’s some sort of difference that we have to be very clear whenever we invest in something. If we’re a consumer, we can have a lot of fun with it, but is it worth the investment? That’s the other side. I think Ser Jing, you can start off not telling us what does Netflix do as a product, but the broader business. I think that’s something that a lot of people don’t understand.
Ser Jing: Yeah, sure. I think when it comes to Netflix, most people today… or at least, if you have come into contact with Netflix only in the past few years would know it as a streaming services provider. That is its main core business today.
But I think what’s interesting is that Netflix did not start out as a streaming services provider. In its early days, it was actually sending out DVDs by mail. In the past, people would rent DVDs from Netflix via the internet and Netflix would then send the DVDs to its subscribers. It was also operating on a subscription business but the subscription was for a DVD-by-mail rental service. That was what Netflix used to do.
I think sometime in 2007, Netflix kind of started streaming, and I think sometime in 2011, it decided to go all in on streaming and let its DVD-by-mail business just slowly wither away. I think it’s still around, but it’s just not…
Reggie: Wait, it’s still around?
Ser Jing: Yeah, I think so. Not too sure but it’s…
Reggie: Serving the boomers.
Ser Jing: It’s definitely not something that Netflix’s management pays much attention to. The focus is purely on the streaming services. I think that’s an interesting bit of history with Netflix that I think a lot of new users may not realize.
Reggie: Yeah. I think the younger people may not even know what is a DVD. Netflix has fundamentally changed the way we consume content in a video form, or at least in a highly produced video format. I think even in video form these days, you’ve got to separate out: short form video, community-led video content and highly produced video content. Netflix is clearly in the highly produced side of things. But what are some core business processes as an investor, we should be aware of?
Ser Jing: Core business processes… As a streaming services provider, Netflix provides content, entertainment content and this entertainment content can be split into both self-produced content or original content, and the other side would be licensed content, content that been produced by other content producers and Netflix then purchase a license to show that program to its audience so there’s these two big groups of content that Netflix has in its library.
Reggie: Okay, great. Anyway, for all of you tuning in, if you have any questions, drop in a comment, we’ll answer it later because Netflix has a lot of changes recently. Can you walk us through what is their business model then? How do they make money and what’s the pricing and all that jazz?
Ser Jing: Yeah, sure. It’s a very simple business model. It’s a subscription-based business. It has only one stream of revenue and that will be subscriptions so these subscriptions can come from either a user subscribing for the DVD-by-mail rental service, which is now a legacy and tiny part of Netflix business.
The other subscription service would be to its streaming services. Netflix is in… I think more than 200 countries worldwide now today but the US still accounts for a significant chunk of its revenue. But it’s very much international business. I think in terms of total users today, it has significantly more users in international markets as compared to the US so it’s a global streaming services provider and all its revenue just comes from its streaming services.
Now, price points vary very widely. I think in the US, you can calculate the average revenue per user. Off the top of my head. I don’t have the numbers now but it does vary pretty widely across the world. I think in the US, if you say average revenue per user is probably somewhere in the low-teens range per month in terms of USD. I can go down to much lower ranges as well in other developing markets where Netflix also recently launched a mobile-only plan. That has a much lower revenue per user.
So there’s a wide range of price points and Netflix charges, but I think it’s still very much somewhere in the region of say a few dollars per month to $20+ per month, depending on the type of subscription plan you’re on and the geography you are in.
Reggie: I think Netflix is making it very hard for content creators like us to charge any higher subscription numbers. Everyone is benchmarking Netflix. It’s like how we benchmark the chicken rice, $2 downstairs… maybe $3. They have set that benchmark price.
But like you’ve pointed out, I’m a little bit concerned… I don’t know if you are concerned that they only have one revenue. It’s such a scale because they are already very big in the US and dominant and there are a lot of competition coming in so are you concerned about the business model in itself? How do you see it?
Ser Jing: I think in terms of the room for growth on Netflix, I think there’s still a significant room for growth. I think if you look at the number… I think in the most recent shareholder letter, Netflix did comment that it has somewhere 800 – 900 million broadband households. Users that you could potentially capture today (that are) subscriber-based is slightly over 200 million so there’s still significant room in terms of the number of subscribers that it can capture.
Of course, there’s also room for pricing increases. I think Netflix is one of those interesting businesses where it always charges a lower price than it can, even though the pricing has increased over time, but it always tries to charge lower than it can and that stems from management’s philosophy when it comes to pricing increases.
What they really want to do is to deliver value for subscribers. When you think that the value that they deliver to subscribers has increased significantly, that is when they come up with pricing increases and they try to keep the pricing increase lower than the perceived value that they had delivered to subscribers.
In terms of the total viewing time, I think people might be surprised. If you look at, say in the US where it is Netflix’s single largest geographical market and where it also probably has the highest penetration rate, I think Netflix is still in the low single digit percentage in terms of total viewing. If you talk about the total amount of time that people spend consuming digital or… not digitial, sorry, entertainment content, watching on the TV, Netflix is still only a low single digit percentage of their total viewing time.
So I think from that perspective, when you look at the number of users that could potentially be won, the pricing increases that could potentially be put in and the potential increase in the total viewing time, I think there is still significant room for the business to grow.
Now, you mentioned about that single revenue stream. I think that is… There are pros and cons to that, right? The pro is that with that single revenue stream, management is laser focused on making sure that it delivers an excellent streaming experience, so that’s the pro.
The con is that if one day, streaming just dies in a natural death, say in the world of cable, then Netflix could be in trouble. I think for now, it’s pretty clear to me at least that streaming is in the ascendancy, right? It is growing and that’s a view that Netflix’s management also shares.
Reggie: Actually, if you think about it, amongst the FAANG (Facebook, Amazon, Apple, Netflix, Google), Netflix has the simplest business model. I love how in three minutes we cover the business model already. I was like 没有东西讲 (nothing to say) already. It’s more content, more consumption, more streaming, more subscribers… pretty much that’s the idea.
That’s very interesting, but amongst a lot of companies these days, a lot of people have all these kinds of non-GAAP measures. They are not like accounting practices accepted… and total viewing time is one of those things that is a non-GAAP measure that Netflix and other streamers will harp on, other streaming providers will harp up pretty tightly. But as an investor, can you help us understand why is this total viewing time so important? Because it appears everywhere. Every analyst use it. So help us understand this.
Ser Jing: Sure. I think when you mentioned non-GAAP, I think it’s useful to differentiate between… non-GAAP often is used to refer to financial numbers that are not based on what is called Generally Accepted Accounting Principles or GAAP. So if you use financial numbers that are not based on this GAAP, then they call it non-GAAP. I think viewing time is perhaps not really non-GAAP per se, but more of like just an important business matrix that can give us a certain window into the health of a business. In Netflix’s case, there’s the total viewing time.
Now, why is it important? Because I think ultimately, as a subscription business, you want your subscribers to stay onto the service. You want a very low churn rate. How do you achieve that? You achieve that by making sure that your service is used often and valued by your users. So I think in this case, total viewing time is a good proxy for the value that users or subscribers can extract from Netflix. If the viewing time is increasing over time, then I think it’s kind of a good indication that subscribers of Netflix are continuing to see value in the service that the company provides.
Reggie: Yeah, definitely and I think in your thesis… for everyone that don’t know, I’m actually on the compounderfund.com, looking at the thesis at this moment in time. You should check out the compounderfund.com, which is a fund that Ser Jing is managing… look at their thesis. I think you talk about growth in other… like beyond US growth. We all understand that US forms about 50% of Netflix’s revenue and it’s their biggest market.
Recently, of course, with the pandemic opening up in the US, we actually see a little bit of dip of subscribers there, but that one I think more people can understand because you go out and you don’t really need to pay for these things so you unsubscribe. I get that and you’re seeing the consumption pattern happening in the US in a more matured fashion. Whenever there’s a… HBO has something, people will subscribe and then three months later, they unsubscribe cause no more Game of Thrones so you’re seeing a consumer habit there forming.
But I’m more curious about what is your take on Netflix’s Asian strategy. How are they trying to grow in this part of the world? They coming into the game is interesting, but there are also very big players in this region already, specifically in China for sure. What do you think is their strategy in this part and what do you like about it?
Ser Jing: Yeah, sure. So I think with Netflix, its international strategy has been pretty consistent based on my observations of the company’s growth over the years. What they tend to do is when they enter a new international market, they will often have a library of US content or content from other countries that in the world that they already have, they put it in the service and then over time, try to grow the local content library.
As they grow their roots in the country, they will try looking for good content producers in that particular country and get them to produce exclusive content for Netflix. At the same time… also go out to hunt for existing content that they can license. So it’s very much entering the country first and showing the audience content that Netflix already has and then trying to localize it over time.
So what happens is over the years, the value proposition that Netflix has for users in a particular country, in my opinion, actually grow because there is more and more localization over time. I think that is in terms of the content strategy, that’s what Netflix is doing and and has been doing.
In terms of the pricing, I think increasingly, we’re seeing Netflix, especially in emerging markets or rather, countries that are considered to be emerging economies, increasingly the company is pursuing a lower price point for the subscription… perhaps going, say mobile-only where the amount of data that needs to be streamed over the web is probably lower and also coming up with basically subscription plans that are more suited to people or economies where the income per population is slightly on the lower end. I think that’s what they are trying to do.
And if you look at Asia, I think there are quite a number of countries within Asia that are considered to be emerging economies or where the GDP per capita is quite low compared to say in the US or Singapore, so I think for those countries, in terms of its pricing strategies, it’s definitely moving towards lower price points.
But what’s interesting is I think in the latest quarterly commentary by the company, it did mention that it hasn’t really seen… the lower price points has not really been cannibalizing the higher price points. In a way, it’s Netflix really expanding the pie.
So perhaps at the higher price points, that’s only this amount of subscribers that can be won, but if it now introduces a lower price point, then there is where you can actually really increase the total number of subscribers that you can get without cannibalizing the higher price points with perhaps better screening features.
Reggie: Okay, okay. But currently, the price difference is really just on where it can be consumed, not so much about all the additional stuff that will come, like video gaming, podcasts and all those things.
Ser Jing: Yup. I think for now, if you look at… and you mentioned gaming, right? That’s one of the new business lines that Netflix wants to enter, but gaming will not be a separate subscription. It’s going to… so for example, I’m a current subscriber of Netflix and…
Reggie: I presume so. You better sign up. You invest so much, better be a user. You must love the product, right?
Ser Jing: That’s a topic for another day… but as a subscriber of Netflix, when it starts to introduce the gaming feature, if I log on to Netflix, I’ll be able to see it there. It will be like a new content category. Today, if you are on Netflix’s homepage, they will classify their content according to genres like horror, Western, action, whatever… and then there’ll be gaming. It’s going to be added on to the subscriber’s existing subscription at no additional cost.
It’s not going to be a new separate line, but it’s going to just be more value that a user can gain from his or her subscription. I think this again, brings me back to the point I made earlier about the way that the management team thinks about raising prices, which is I first must deliver more and more value for my subscribers before I have the right to go and ask for pricing increase. I wouldn’t be surprised if after the introduction of gaming and if it catches on and in terms of usage trends and so on, then perhaps we may see another round of pricing increases after that.
Reggie: Yeah, which is always the exciting part. But interestingly, you actually believe that Netflix has a very strong balance sheet which… they have a lot of debt at this moment in time and they’ve been building more and more debt to do originals and all that kind of stuff. Can you kinda give us a little bit clarity why you think that they actually have a stronger balance sheet than before despite so much debt?
Ser Jing: Yeah. Sure, sure. In my case, when I look at a company’s balance sheet, I genuinely like companies that have more cash than debt on the balance sheet. But in the case of Netflix, I wasn’t worried despite knowing that Netflix has significantly more debt on its balance sheet than cash.
The reason is because I think that there is a very good reason why Netflix has a lot of debt on its balance sheet and it’s because of its content strategy. I think sometime in 2013 or so, Netflix started to pivot heavily towards producing original content. Now, the interesting dynamic when it comes to original content is that you first have to pay cash upfront to produce that content and then it’s able to be monetized or rather, hopefully be able to be monetized over a very long period.
What you first need is that investment upfront to create that content. As Netflix ramps up its spending for original content, beefing up its content library, delivering more value to subscribers, what has happened is that it had to take on more debt over time to be able to finance that original content spending.
So, the reason why I think the balance sheet is okay despite the debt is because I think that that kind of spending on that original content is actually intelligent spending. It’s to build an asset or to build a series of intellectual property that can be monetized over a long period of time. If we look at, say the churn rate that Netflix has, it’s the lowest or one of the lowest among streaming services providers, and it’s very healthy from a monthly perspective. Netflix does not officially released its churn rates, but there are third party data providers that kind of try to guess that and most of the numbers that I’ve seen are point(ed) to very low single digit churn rate on a monthly basis for Netflix. What it means also is that the annual churn rate is also very low for Netflix and so what this means is that it has a very… what do you call it… insight…
Ser Jing: Yeah, correct. Very sticky revenue, and so therefore it has a lot of ability to see ahead of time. How much revenue will I be able to get in year one, year two, year three and so on? So it has a very good view of the type of cash flows that you can bring in and that helps it to be able to plan out the servicing of the debt that it has. It also helps to plan out in terms of repayment of the debt that it has.
At the same time, I think over time, we will also be able to see Netflix’s revenue grow significantly… or rather, the cash flows that you can bring in from the subscribers start to significantly outpace the cash outlay that it has for content production. I think when it comes to that, then that is when you can slowly start paring down the debt on its balance sheet to a less risky leve. But I think ultimately, the balance sheet where it has more debt than cash is still a risk to think about and that’s something that I did mention as well in my investment thesis.
Reggie: Fair, fair. It’s pretty interesting how they can have such a low churn and keep raising prices. They have increased prices quite a few times and I’m like wow, people still use it so it’s pretty interesting. But do you think the landscape has changed now that there are all these new providers that are coming in and they’re not coming in just trying, right? They are coming in now. They come in with a whole war chest. Are you concerned?
Ser Jing: I think my answer is slightly nuanced. What is happening is that Netflix is today, I think the largest spender on content. It’s easily going to be spending somewhere between $15 or $20 billion on content production in this year and that is a phenomenal, a formidable amount of capital that anybody has to spend on content.
But what has happened is that Netflix has the largest subscriber base in the world. The cost per subscriber is actually one of the lowest, if not, perhaps the lowest among all its other streaming services competitors. What it means also is that Netflix can spend a lot more in absolute dollars on content and yet still keep costs low on a per subscriber basis and that’s, I think, a very strong and beautiful dynamic that other streaming services providers cannot achieve.
So yes, even though a lot of people are coming in hard with a lot of capital, the sheer amount of capital that Netflix is pumping into the business is something that I think is very difficult to compete with. I think what’s also interesting and important is that because it has such a… it has a decade long or more head start in streaming, it’s able to design a better user experience, user interface. That’s one.
It also has a lot more data on the viewing preferences of users and I think that it goes into the calculus, when the company thinks about what content should it produce, the types of content you should produce, and also the type of content that you should license and at what price.
So I think the pricing and the type of content, that’s also very important. I think in the case of Netflix, because of the data that it has on users’ viewing preferences, it’s able to make much smarter investments in those areas as compared some of its peers.
I think overall, I’m not too worried even though there’s all these influx of… what do you call it?New competitors coming in… and I think, if you look at, say what Disney+ has done over the past one and a half years is phenomenal. They have, I think today grown… I don’t have the numbers off the top of my head, but they achieved the target that they set themselves…
Reggie: For three years.
Ser Jing: Yeah. It’s accelerated by three or four years by the amount of subscribers that Disney+ can bring in. But at the same time, also it’s happening at the same time is when Netflix has also gone on to sign up a tremendous amount of new subscribers. I think, based on Netflix latest forecast, I think by the end of 2021… so from the end of 2019 to the end of 2021, in that two year timeframe, I think Netflix is expecting to win or rather to have about more than 50 million new subscribers. So that’s still a very substantial number of new subscribers and that’s happening at roughly the same time as when Disney+ is reporting its blockbuster growth, the numbers of subscribers as well.
So I think when you look at that, from that perspective, I think sometimes competition… having new streaming services provider enter the arena is not necessarily a dire competitive threat for Netflix. I think the overall bigger picture really still has to be about the stream…
Reggie: … cable.
Ser Jing: Yeah, exactly. I think more about streaming versus legacy television more so than streamers versus other streamers.
Reggie: Nice. We’re also streaming now. We are on Twitch by the way guys, just saying. We’re getting cool. I totally get that and it’s pretty phenomenal because I think for a lot of people, when they look at a company… a lot of times, they look at a company, I think for the newer investors, they look at it in isolation. So they look at it like “oh, Disney is doing so well”, but when you broaden it and you see actually, a lot of people are all doing very well. The broad landscape is all doing well. Everyone’s just riding high and it may not be a winner take all and it may not be a one-provider-at-the-end kind of game.
Ser Jing: I think in most markets, there will be a few winners that will emerge even if there’s a huge fight, a huge war, if you will. There will eventually still be a few winners. I think that is often the case when it comes to outcomes in the business world. It’s never really a case of just one winner. Even in industries where network effects are super strong, say in payments, you have so many runners in the payment space as well, right? There’s like Mastercard and Visa, for example. Both have done very well even though they are literally direct and very fierce competitors of each other and for full disclosure, my fund also owns positions in Mastercard and Visa as well.
Reggie: Nice. Good. Yeah, totally agree. I totally get that. But it does matter who is the management, right? Who is managing these companies and then how are we going to get it going? I love how Netflix is so simple as a business and they do have a lot of quirky management that has published all sorts of weird leadership books that are counter corporate culture. So you’re gonna walk us through a little bit more of how you think about their management?
Ser Jing: Sure. Actually, the study of the management team is a very important part of my research process with the company. I like to look out for management teams that have integrity, capability and the ability to innovate.
In Netflix’s case, I think it it has all of these ingredients. I think integrity, if you look at the way that the compensation of Netflix’s management has changed over time, it’s very much roughly in line with the growth of the business in the company so I like that. I like seeing compensation tracking the growth of the business.
But I think the really interesting aspect of Netflix’s management is just the capability and also the ability to innovate. I think the company… one very interesting aspect was Reed Hastings, the founder and current co-CEO of Netflix was interviewed many years ago by… I think it was Fox Magazine or Fortune… can’t remember which, and he actually said that we named the company ‘Netflix’ and not ‘DVDbymail.com’ for a reason and that is because from very early on, they knew and foresaw that the television or entertainment content should be delivered over the web.
That was the time when streaming wasn’t in the mainstream lexicon yet. And so, I think he used… he did not use the word ‘streaming’ but I can’t remember what phrase, what type of phrase he used, but basically, it was describing the idea that entertainment content should be delivered over the web.
In 2011, I think the Netflix management made a move that made me deeply admire them. Earlier on in this podcast, I mentioned that Netflix’s business started off as DVD by mail. That was the cash cow. They were generating healthy cash flows from that particular business. But in 2011, the management decided to just spin that off into a company called Qwikster. I think today, if you google ‘Qwikster debacle’ or something, there’ll be a series of articles that describe what happened during that time.
What happened was that Netflix’s management wanted to spin off Qwikster and basically completely cut off the DVD by mail business from Netflix and they wanted to focus entirely on streaming. But there were a lot of constituents of the company that were not happy with that move and eventually, management retraced their steps and said that “okay, we’re still going to keep the DVD by mail business. We’re not going to spin it off but we’re not going to spend a lot of our management resources on that. We are going to be focused on streaming.”
I thought that was really interesting because I think first, it’s really rare for a business leader to want to just completely cut off his existing cash cow and focus on where he thinks the world is going to go in the future. I think that’s a hallmark of very strong sign of a management team that has its eyes firmly on the future. There’s this overused quote in the world of business that I think originated from this ice hockey legend called Wayne Gretzky which is that you should skate to where the puck is going and not where it has gone to.
The idea is that Netflix’s management team wanted to skate to where they thought the world would be heading towards, which is a world where entertainment content is delivered and mainly via streaming. I thought that was a very strong sign of innovative management team and the fact that they managed to pull it off judging by the number of subscribers they have today, the revenue base that they have today… more than 20 over, I think something like $25 or $26 billion in trailing revenue today. I think that is a very strong sign that this is a company that is executed very well. That’s the capability portion.
The innovation portion is really… you know, often times we talk about companies riding on tailwinds. You can say “oh, I’m riding on the e-commerce tailwind” or “I’m riding on the streaming tailwind” and whatnot. I think there are categories of companies where they are the ones that are creating the tailwinds and I think in the case of Netflix, it is such a company. It essentially created or brought to the world’s attention onto what streaming can be. It created that kind of tailwind for itself and has been riding on it so I think that is one of the things that I really like about Netflix, which is just the strength of the management team and how it has grown the business over time and how it thinks about its competitive landscape.
On the competitive landscape topic, this is something that I often bring up whenever people talk about Netflix with me which is that when you think about competitors, you often think about other streaming services providers. But to Netflix’s management, that is not the case. Many years ago, Netflix’s management team actually came out with an essay called the long-term view… or is it the long view? Something like that. In it, it mentioned that… they talked about their view towards competitive forces as well.
What the company mentioned was that competition actually isn’t just the streaming services providers. It’s actually anything that you spend your time not on Netflix. So if you are exercising, if you are watching a movie on say, Disney+ or Amazon Prime or something else, or if you are streaming music iinsteand of watching a show, you’re playing a computer game instead of watching a program on Netflix. That is competition. Any activity that you are doing besides streaming on Netflix, that is competition and I think that’s also a very interesting way to think about things that is not common.
But what I really like about the aspect is that when you have such a broad view of what competition really is, I think it becomes harder… or rather, the chance that Netflix can be disrupted by competitive forces from different angles is actually lower, right? Because I think it’s harder for the company to be blindsided.
Today, you see the company trying to venture into gaming which is not really related to streaming at all but if you think about the way Netflix frames competition, then I think that move into gaming makes very strong strategic sense, right?
Reggie: Cool. Yeah, very excited about Netflix. I get it. So yes, every time a company does a big pivot… I do think video gaming is a big pivot because there’s a whole operational process that needs to come out for Netflix. It’s not like just a new genre of shows or something. There’s a whole ops that comes out and they have actually hired quite a guy to come into the team. I think Mike Verdu was from Facebook… used to be in EA, Atari and what have you. They brought in quite a leading person in this space to come in.
But every time a company pivots, some investors will like it, some investors won’t. I’m sensing that you like it. Can you walk us through in your view, in a little bit more detail, why do you think this is a good move for Netflix based on their business model?
Ser Jing: Netflix’s business model, as I mentioned earlier is it’s subscription based and how do you maintain a healthy subscription business is that you really want to continue to capture the attention of your subscriber. So in this case, if you can introduce gaming and if it works out well, you capture more attention from your existing subscriber and it increases the stickiness of the product.
I think from that perspective, it excites me that Netflix now has another avenue to improve the stickiness of the product that it has for subscribers. The other interesting aspect is that because Netflix is a pure subscription business and it does not see gaming as a new subscription line, although in the future, it may just kind spin off gaming as a new subscription service… but for the time being, because gaming is really seen as an additional customer acquisition and customer retention tool, what it does is it frees up gaming developers that Netflix works with to really let our imagination run wild to really just produce high quality games that can capture user attention instead of having to worry about how should I monetize the game?
Because today, if you look at a lot of games, they often have to worry about the monetization model. Do I want to do a freemium model, and if it’s a freemium model, what kind of in-game content should I sell? If it’s a subscription model, sometimes you also want to have in-game content that you can sell. If it’s a one-off sale model, then you also have to worry about how do I generate that kind of recurring revenue? And then the question becomes what other types of in-game content can I sell if I’m actually selling the game on the one-off model?
There are a lot of trade-offs that I think game developers have to make in terms of between the gaming experience and between the potential monetization models. I think sometimes, both of these things can come together very well, but sometimes it’s a trade off that game developers have to make. But in the case for Netflix, because of the way that they are framing, the development of that particular business, I think it really just frees the game developers that Netflix is working with to just purely focused on creating excellent gaming content without worrying about the monetization aspect of it.
So I think that it’s really interesting as well because you never really know what kind of new gaming models that can appear. I think what’s also interesting is that in the early days of this venture at least, Netflix is going to focus on producing games that are related to its existing intellectual property but over time, it may… and I’m looking forward to see whether or not such games can help to extend the longevity of Netflix’s existing IP and also, besides extending longevity, could it increase the overall fan base interaction with Netflix’s content. Yeah, these are the areas where I’m just excited about.
Reggie: Yeah, for sure. I think it’s going to be very interesting because sometimes when we play games, some of the in-game video dialogues, I hope that they could extend it. That could be a lot more. It’s like World of Warcraft. You play WoW and you see the Warcraft movie. I was like “oh dude, this could be so powerful.” They could just spin up a whole franchise and then you could consume the movie and then they could ping you and say “you want to continue to play the game? Connect with your friend” or something.
So it kind of builds up the whole eco… of course, this is all imagination. We don’t know how it’s going to come out yet, but to me, it’s like the Disney model. You build content but then you put it into different ways of monetization so Netflix is doing it in a different fashion, going digital. I’ve been telling people game franchisors will be the future of online content.
Ser Jing: Yes, yes.
Reggie: You cannot underestimate the value of games as a franchise, as a license, as a brand itself.
Ser Jing: Yeah, absolutely. I completely agree with you. There’s potential for Netflix to build games from its existing content suite. I think like Stranger Things, for example, could make for a really interesting game. It could be like a Half-Life kind of game where you have horror and action mixed in with the games. So that’s pretty cool.
On the other hand, if the gaming thing really does take off, you could even see movies or TV series being made from popular gaming franchisors that come up on Netflix’s gaming studio. But all of these is just super early days. There’s nothing concrete yet when it comes to what Netflix is going to introduce with its gaming arm so we’ll see.
But I think as you rightly pointed out, I think the person that is going to head or lead the game business has some very impressive resume and yeah, I think it’s a really good hire done by Reed Hastings and his team.
Reggie: Yeah. Atari leh. Atari so old school, such a long time ago kind of thing. This guy definitely has a lot of experience, but okay. So all these positive about the management and all but we cannot forget that they did miss out on the Roku avenue. Roku is the hardware that got… Netflix rejected the idea and then the guys decided “okay, we’ll leave and we would just go and do that hardware streaming”… it’s like Apple and what did they call it… the box. That’s how they started. But now they have integrated with most of the TVs and hardwares and what have you, so how would you rate management when it comes to missing out on this very big hardware spinoff at that point in time?
Ser Jing: I’m not super familiar with that particular history. I know only like a little bit here but if I look at Roku’s business model today, it’s very much tied to digital advertising, to connected televisions. This is just a very different type of business that Netflix wants to pursue. Netflix is very heavily anti-advertising… okay, I wouldn’t say anti-advertising, but it doesn’t advertise at all as a revenue stream.
Interestingly, and I think also in the latest quarterly earnings conference call, there was a question about sports and why Netflix is not pursuing sports. Reed Hastings or one of the members of the management team actually say that Netflix as a company, they are very laser focused on their value proposition, which is on demand streaming without advertising, so it’s very laser focused.
Sports revolves around a fixed time and is supported by a lot of advertising so it’s antithetical to the Netflix’s business model and hence, it’s not something that Netflix is interested in at the moment. Things could change in the future, but at least for a long time in the past and now, it’s not something that it’s interested in.
In the case of Roku as well, where it’s really just… I think it’s like a conduit for advertisers to be able to do advertising more effective via digital TVs. I think from that perspective, there isn’t much connection between the Roku business model and the Netflix business model.
Reggie: So in that sense, you would actually rate the Netflix management better because they have rejected this whole other business model and they are laser focused on it so they stayed on their track in that sense. Because not every opportunity, you should pick it up so that’s what I’m trying to find out.
Ser Jing: All right. Sorry, I kind of misunderstood your question a little bit. No, I think I am ambivalent on what Netflix’s management team has done with Roku. I do not have any positive nor negative opinions. My comments earlier were just on the differences between Roku and Netflix business model today and why these two companies may not be a good fit for each other.
Reggie: Okay, Yeah, that’s good enough. I think Netflix has a lot of good things to give people. It is where it is today. It is pretty big in itself. On the discussion of the moats of the business, I think you already shared a lot of stuff, but is there any other thing that we should know about, either as a company… where do you see? Why do you think it’s very resilient going into the future?
Ser Jing: Yeah, so I think in Netflix’s case, the biggest competitive advantage is really Reed Hastings, the CEO of Netflix. I think he’s the smartest guy in the room, in the entire entertainment space. He’s combining software smarts with digital entertainment smarts. I think when you have that combination, which is… I think rare, it’s harder for competitors to try and compete with somebody like Reed Hastings. I think he is really the single biggest competitive advantage that Netflix has.
I think everything that Netflix has built to date stems from his vision, his earlier on vision. Netflix wouldn’t have the 10+ years of head start in streaming if Reed Hastings did not push the company toward that vision he had of streaming, so everything stems from Reed Hastings and I think as long as he maintains that kind of laser focus on continuing to deliver and grow the value proposition Netflix has for its users then I think the company should be in pretty good hands.
I think that there’s still a long way to go before there is a shake-up in the streaming services space as well. I think today, in terms of streaming, it’s still only maybe about a quarter or so… or maybe 30%, something like that, of total viewing time in, I think in the US or global… can’t remember which, but the idea is that there’s still a lot of viewing time for streaming services providers as a whole to win.
I think that in Netflix’s management can say that perhaps when that ratio flips… now it’s 70:30, 30% streaming, 70% traditional TV. But when it flips to say 30:70, meaning 70% streaming or 60% streaming, then there is when potentially you can start seeing shake-ups happening where the streaming services providers start competing very fiercely with each other to win subscribers from each other. But even then, I think when you look at who is likely to have the largest subscriber base and hence the lowest content cost per subscriber, I think Netflix will have to be in the conversation.
Reggie: Yeah, that’s cool. If you guys have any questions, drop in the comments section. We’ll reply you, but I think Netflix is a very simple business model and a pretty, pretty good team and they’re just continuously doing what they do. So it’s quite a flywheel, right? They’re not doing a lot of big changes.
Of course, the whole new gaming thing is a thing, but that’s just too early for us to really comment as to is this really working or what have you. I give it maybe two or three more years and then with more data we can see if that business model actually works.
But to sum up today, can you just walk us through, what are some of the risk factors that you think Netflix will face and to you, where is the future?
Ser Jing: Yeah, I think earlier I mentioned about the amount of debt that’s on Netflix’s balance sheet. I think that is still a risk on Netflix. In 2020, it started to give a glimpse of the types of cash flows that you could potentially produce when it’s in a more steady state when I think when it can slow down its original content spending, then we can start really seeing the cashflow starting to generate. But for now, it’s still burning… cashflow is still not very healthy. That’s a big risk to watch, that weak balance sheet. I think generally speaking, when a company has more debt than cash, that always puts it in a riskier position than if it has more cash than debt, so that’s one.
Another important risk is as I mentioned, competition. I think that Netflix has a very strong, competitive position, but you never know. Things can change. Like you rightly pointed out earlier, there are more and more of these streaming services providers coming in. Maybe, for all you know, that could be a very new kind of… a new app or something that pops up from nowhere that fucks up user’s attention significantly…
Reggie: Tik Tok.
Ser Jing: Yeah, Tik Tok. I believe that Netflix will actually see Tik Tok as competition as well. So, you know, you never really know. There’s no guarantee that I think Netflix will continue staying on top, so that’s one.
There’s… I think very high key man risk as well. Like I said, I think Reed Hastings is the competitive advantage for Netflix and if the company does lose him for whatever reason, then I think that could deal a very big blow to Netflix. On the key man risk topic, I think there’s another person worth mentioning which is Ted Sarandos, who’s also Netflix’s co-CEO. He was promoted to the position fairly recently. Prior to that, he was the head of content at Netflix.
Again, I think it’s really a smart move by Reed Hastings to promote Sarandos to co-CEO. I think that’s one way you can give career progression for somebody who is very important to the future of the company as well. Sarandos has been leading the content production efforts of Netflix for a long period of time so a lot of the growth that Netflix has experienced in its content production has really come from the leadership of Ted Sarandos.
I think the fact that he’s now a co-CEO lowers the risk or the chance that Sarandos would grow bored of his job and wants to leave Netflix so that’s a key man risk. I think these are the three kinds of… oh, and I think the last risk would actually be COVID-19. I think depending on how the virus develops… because Netflix, ultimately as a streaming services provider, its business health actually depends on the introduction of new content from time to time.
If COVID-19 starts to worsen significantly from here and if countries around the world start shutting down human movement significantly again, then that could create a severe vacuum in terms of the original content that Netflix can introduce to users, to viewers. If that happens, then I think the growth of the business could be affected.
Reggie: I have to say Netflix’s kind of content is hard to produce. It takes a very, very big team and all that jazz so I totally get what you’re saying. It’s not like two of us that are like oh, we just stream in and just talk cock and have a good discussion and that’s it. They have a very long production process and it’s international so I get it from a production standpoint.
Ser Jing: And I think actually from… perhaps maybe worth mentioning as to one of the advantages that Netflix has over its peers is that because it’s such a global streaming services provider, if you’re an aspiring or very talented content producer, you know that even if I were to build a piece of content that is geared towards my local audience… say like a Korean content producer building for Korean audiences, there’s a chance also that my content will catch on with many other viewers across the world because given the nature of the streaming service that Netflix has, I’m sitting in Singapore and watch content that’s produced in the Philippines, in France, in Korea, in any other countries.
I think what’s interesting also is that Netflix has realized that often, the localized content is also able to win the international audience. I think that’s also something that is to their benefit as well as a competitive strength that Netflix has because it allows the company to pitch itself better to content producers, makes the company more attractive to work with when it comes to content producers thinking about which platform should I be on.
Reggie: It’s the whole developer ecosystem, like how people built on iOS first these days. I never saw that way, but yeah. As a content producer… Netflix, you should call us so we can do content for you. Very happy to do that. Just email@example.com.
I think we’ve covered a lot about Netflix and for everyone else that wants to see your full thesis, go to compounderfund.com or they can ping you, LinkedIn, what have you. They can probably just talk to you directly if there’s a need to.
Is there any last things you want to add for us before we sign off today?
Ser Jing: No, nothing.
Reggie: Okay, great! That’s Netflix for all of you. If you have any questions, come to our Telegram group and thanks for joining us. 10:00 AM, you should be working, but nevermind. You join us… is good choice. That’s it for today. Thank you Ser Jing. Take care.
Ser Jing: Thanks Reggie for having me. Thanks everyone.
Reggie: I hope you learnt some new stuff today and definitely recognize that investing is a personal decision. We’re not here to give you any recommendations, but we’re always happy to geek out with you on interesting companies and trends for the future.
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