No. 346: Netflix’s Boom Explained

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To understand the explosion of the streaming media industry, look at in the context of digital-native brands. To understand the limitations of today’s digital-natives, look at it in the context of streaming media’s growth from fringe idea to Hollywood stalwart.

In 1999, Blockbuster Video was twelve years old with 9,000 stores. Just five years prior, Viacom acquired the company for $8.4 billion dollars. At the time, Netflix was the one-year-old challenger brand. Between the two, we saw the first of its kind. A dynamic between old vs. new and traditional vs. challenger that we would see play out over the next decades between traditional and direct brands.

Timing is everything when an incumbent challenges the titans. On an early January morning in Columbus, Ohio, the former-CFO of Enron Corporation stood before a group of nearly 60 of the city’s entrepreneurs. He narrated the infamous company’s successes, failures, and hidden truths. The Entrepreneur’s Organization commonly hosts keynote speakers but this session was different. We all knew his story. And Andy Fastow was frank in his narration of, he was deeply contrite and his messages illuminated the history in ways that a news broadcast wouldn’t allow – now or then. He walked the audience through the step by step of a company that was unstoppable until it was; he was even more candid in his personal shortcomings. But what you may not have known? Enron played a small role in determining the outcome of today’s streaming wars.

In 2000, Blockbuster Video declined to acquire Netflix for $50 million. Rather, it chose to compete. In doing so, the company agreed to a 20-year deal with that same Enron Corporation to deliver video on demand (VOD) though Enron’s fledgling broadband services division. With this agreement in tact, Blockbuster chose to delay the pivot from bricks and mortar to direct-to-consumer. This was a decision that the company would almost immediately regret.

The Blockbuster executives, who never liked the VOD concept themselves, used the lack of content as their excuse to abandon the partnership with EBS in 2001, saying that they wanted to stay focused on Blockbuster’s bricks-and-mortar stores rather than pursue an online business model. [1]

The difference between success or failure in a category comes down to three variables: (1) timing (2) technology (3) adoption rates. More, in a moment, on the third and final variable. Blockbuster’s timing couldn’t have been worse: Netflix’s DVD business model was catching on and Enron’s team would soon make a decision that would crater an entire company in epic fashion. It was a company that Blockbuster depended on, even if they weren’t in a hurry to do so. It was the typical case of an innovator’s dilemma.

When Enron crashed, Blockbuster’s hopes crashed with it. Their VOD technology was capable but their managers chose not to deploy it, eschewing long-term innovation for short-term profits.  Blockbuster was the first-mover in an industry that we didn’t even know we would need. But the company did not want to expand on that early advantage. By the time that Blockbuster’s c-suite identified the need to compete in the VOD (video-on-demand) industry, it was too late. The technologists of the company wanted to pursue a direct strategy, its managers wanted to maintain the company’s emphasis on physical retail.

The DTC Brand Parallel

The direct-to-consumer moniker has been called into question. You’ll find it used in digital media positioning and in retail branding, alike. But what does it mean to be a DTC brand anyway? One private equity investor called the previous month’s retail news “the trinity of doom” for a cohort of DTCs. You know many of them by name. A number of these brands are coveted portfolio companies held by the brightest consumer venture capital firms in Los Angeles, San Francisco, and New York.

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The boxes tell the story: “Ar” for Netflix: .73 / “Ar” for DTC retailer: .12

Venture firms like Forerunner, Lightspeed, Lerer Hippeau, or agency / venture hybrids like Bullish or Science Inc. have investment theses built on the internet as a primary acquisition tool for these modern brands. But in response to the Bain Capital investor who cited the trinity of doom, the veteran venture capitalist replied: “Harry’s is not a DTC brand. Casper is not a DTC brand.” More on this in a moment.

The conversation between Bain Capital’s Magdalena Kala and Bullish’s Mike Duda caught my attention because it illustrated a growing disconnect in the private market. Private equity is the traditional means of scaling a retail brand that one-day could enter public market. Rightfully, Kala sees things her way. It contends with the current state of the industry. Venture capital is about twelve years into democratization of eCommerce retail, a process that has seen more failure than success. Even so, Mike Duda is as gifted as it gets when it comes to picking early winners. In 2007, dozens of digitally-native brands existed. Today, that number has swelled into the thousands. With the accelerating democratization of DTC, both consumer P/E and venture financing roles have grown in complexity.

The first quarter of 2020 was consequential for the DTC industry. Walmart announced that it would no longer acquire brands, incubating them instead. Casper repriced its initial public offering. The stock is trading at just a third of the value that the retailer maintained just a few months prior. And Edgewell Personal Care abandoned the acquisition of Harry’s after it was thwarted by the Federal Trade Commission.   

As was the case in the early competition between Blockbuster Video and Netflix, timing was a factor – Blockbuster was doomed regardless. Here is a super simple visualization of what I see.

(T * Tr) / (Ar)

T represents timing of the product’s development. If the timing is correct, place a “1” at variable T.  Tr represents the technological capabilities of the product. If the technology is good enough, place a “1” at variable Tr. The third and most important variable is adoption (Ar). I wonder if we could say the same about today’s market for DTC exits? Objectively, the percentage of success has been dismal at best.

Emerging industries rely on the adoption rates of key technologies and or behaviors. In Netflix’s case, the higher the adoption of streaming technologies, the easier it becomes to market their services. In this context, around 60% of Americans consume Netflix programming, according to Statista data. The adoption figure (Ar) would be .73 [5]. As adoption climbs, the figure is closer to “1.” The three key variables for emerging technology: timing, technology, and adoption rates for key technology.

Nearly every DTC narrative will be influenced by these three variables: technology (T), timing (Tr), and adoption rate (Ar). Blockbuster’s management would have devoted an enormous amount of energy and resources to influence T and Tr without the Ar to make good on its investment. Streaming, in 2001, was an innovation that the market wasn’t yet ready for. In fact, it would be another six years before Netflix pivoted away from DVD and towards video-on-demand (VOD).

The introduction of streaming was truly radical for that time. Netflix’s pivot to streaming wasn’t all that radical—as we’ll see, it was actually a logical extension of what the company had already been doing. The fact that Netflix was willing to essentially bet the entire company on streaming, however, definitely was radical. [2]

Consumer demand for streaming video was practically non-existent in 2001. Even in 2007, streaming technologies were sub-par. Consumer broadband connections lacked capacity to handle high-resolution video. Even worse, when Netflix went live with VOD, it could only work on computers that were running Windows with an Internet Explorer applet to download before the application would work. Twenty years later and the Ar reflects an ecosystem that is dependent on streaming as a primary source of entertainment.

Jeff Bezos, Netflix, and The 2020 Oscars

Web Smith on Twitter

Netflix outranks ALL studios in 2020 Oscar nominations.

In the first 30 minutes of the 2020 Academy Awards broadcast, Netflix’s programming, Amazon’s technology, and Amazon’s polarizing founder stole the show. Between Netflix’s record number of nominations or the comedic barbs pointed in Bezos’ direction, viewers were reminded that two technology companies maintain a stake in Hollywood’s future. Netflix earned 24 nominations while Amazon earned one. However, Netflix exists on Amazon Web Services, a fact that anoints Bezos the benefactor of Netflix’s seamless growth and the beneficiary of its Hollywood promise.

With the help of AWS and an unparalleled marketing flywheel, Netflix began and remained a pure DTC product and their marketing has become an efficient funnel that reflects this acquisition structure. Hilary Milnes writes:

After leading the Academy Award nominations, Netflix took home two prizes last night at the Oscars: One for Best Supporting Actress, which went to Laura Dern in Marriage Story, a Netflix movie; the other went to American Factory for best documentary. Other entrants, including The Irishman and The Two Popes, were snubbed. [3]

The Oscar telecast was uncomfortable for Netflix, in this sense. The Irishman earned ten nominations and won zero, leading many Hollywood insiders to suggest that Netflix should go the way of DTC brand retailers, eschewing the direct model for the proverbial omni-retail blend. As one Academy member explains, Netflix should leave their DTC model behind:

If Netflix walks into cinema chain offices with a barrel of cash and, say, a 30-40 day window, that might be a game changer. Financially it would behoove them to give away most or all of its box office receipts on one or two movies a year in exchange for a distribution release that doesn’t rely on music halls and sub-basement art houses for its theatrical run, which might in turn result in a date with the Oscar podium every February. [4]

This would be a grave error. While winning awards is always the preference, I’m not entirely sure that it should be Netflix’s KPI. Awareness and mentions are the key performance indicators; in this way, award nominations and traditional hype cycles may suffice. This allows Netflix to continue growing without spend attrition: advertising for an outcome that may not affect bottom line sales. A theater distribution model increases spend attrition, lowering the LTV of Netflix consumers by allowing viewership without membership tie-in.

There is only one way that viewers can consume Netflix content. Any organic mention of its programming operates as a super-charged sales funnel. The award show appearances have and will continue to grow Netflix users while solidifying the platform as a venue for original, Hollywood-caliber content.

This strategy also allows the media company to continue its unparalleled data collection practice, perhaps the one true advantage of a pure, DTC strategy. Similarly, Harry’s and Casper initially set out to build direct-to-consumer companies but eventually yielded to traditional distribution as customer acquisition costs rose and growth became less efficient. One could argue that the market wasn’t yet ready for direct brands. While the two sub-categories have similar delivery mechanisms, the Ar was drastically different: .73 vs .12.

Netflix, Amazon, and the cadre of streaming services have a future in critically-acclaimed film production; the market is accelerating in that direction. In 2023, Statista projects that Netflix will have 177 million viewers in America. In contrast, cable channels like ESPN have lost nearly 20% of subscriptions in the previous five years. This trend plays in streaming industry’s favor.

Meanwhile, analysts like Matthew Ball suggest that theaters have their own concerns to consider. Frankly, film-goers are showing up for fewer Oscar-quality performances. The box office is growing thanks to “theme park movies.” Ticket sales are falling, however.

The challenge is more fundamental: The role of the movie theater has changed. What used to be a forum for all types of art is now largely the domain of “theme park movies”—Avengers: Endgame or Star Wars: The Rise of Skywalker—and “museum pieces,” such as 1917 or Get Out. And audiences have ruthlessly high thresholds for both. [5]

In 2020, Netflix led all studios in Academy Award nominations and yet, the platform has yet to realize its “Hollywood Boom.” It merely hasn’t happened yet. As the economics continue to shift in Netflix and Amazon’s favor, there could be a future that requires Netflix economics for critically-acclaimed works. Ar is moving closer and closer to “1.”

And this is the difference between Netflix’s fortunes and that of today’s direct retail brands. Whereas as 60% of America streams Netflix content, only 12% of retail is transacted through eCommerce. Technological adoption rates are critical. Consider if the foot traffic of American malls, at mall retail’s peak. Now imagine that horse and carriage was America’s primary means of family travel, at that time. Or imagine the lacking network effects of Twitter, Facebook, or Snapchat in an America that chose to stick with the tech stack of the Motorola Razr. Or remember that General Magic was well-ahead of its time, inventing touch screen dynamics before processors allowed for their prowess.

Consider this excerpt from the FTC’s comments on the now-thwarted Harry’s acquisition:

Any new entrant would lack Harry’s early-mover advantage in the now-mature DTC space and on the now-crowded shelves of brick-and-mortar retailers.

As Mike Duda mentioned, DTC is a misnomer for most physical goods. Harry’s early-mover advantage wasn’t much of an advantage at all. Neither was Casper’s. Like many of their venture-backed peers, both companies set aside their DTC strategies for costly omni-channel growth. Imagine if the United States was at a point where, like China, eCommerce was closer to 40% (Ar = .4) of all retail volume. Harry’s wouldn’t have needed shelves of brick-and-mortar retailers at all. And it’s likely that the FTC would have permitted the acquisition to move forward. The competitive pricing effect of Harry’s moving into physical retail was the primary citation against the brand.

In this way, Netflix’s current success is somewhat of a glimpse into the future of brand retail. Reed Hastings’ instincts were special; he evolved his technical specifications for a market that was awaiting the Netflix that we know today. Timing is everything when challenging the titans. The direct-to-consumer strategy works. As history suggests, the adoption rate of consumer technology is a greater influence than we give it credit. Study those figures and you may understand the future of an industry.

The shift from physical-to-digital commerce is evident within the streaming media industry. Actresses are thanking Netflix in acceptance speeches and Jeff Bezos is laughing at divorce jokes in an A-list audience of awards shows. By comparison: thousands of direct brands are competing over what amounts to just 12% of all retail volume. In this way, DTC brand retail is closer to the Blockbuster Video phase than the Netflix era that succeeded it. The writing is on the wall in yellow and blue.

Report by Web Smith | Art: Andrew Haynes | About 2PM

Member Brief: The New Magazine Stand

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It was a walk past Graydon Carter’s Greenwich restaurant that led me to rethink my opinion of the media industry. At the time, I was a discouraged Director of eCommerce at a media brand and things weren’t going as planned. I was missing something and I couldn’t quite figure out what. The thoughts that I’d later publish on the law of linear commerce hadn’t yet fully formed in my mind, nor had my understanding of the sociological inputs that influenced the media industry as a whole.

This member brief is designed exclusively for Executive Members, to make membership easy, you can click below and gain access to hundreds of reports, our DTC Power List, and other tools to help you make high level decisions.

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No. 345: The Arming Of The Rebels

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Joann King Herring sat across the living room, lively and engaging as ever. I was standing in her world. As a 16-year-old junior at Houston’s Jesuit Preparatory School, I was a lower middle-class outsider thrust into a world that I couldn’t fully grasp at the time. The geopolitical concerns of the 1980s were long past (or so we all believed at the time). But the 70-year-old socialite and philanthropist still carried herself as though she influenced foreign policy, and in the home of a mutual friend in Houston’s famed River Oaks area, Herring still held court. In a small corner of a major city, she was a titan that influenced outcomes a world over.

It was 1999 and, perhaps, the first time that I heard the phrase “arm the rebels.” Herring was a friend to a Texas Congressman named Charlie Wilson and four years after that meeting, their story, Charlie Wilson’s War, would be on the New York Times‘ best seller list [1] before getting turned into a major Hollywood motion picture in 2007. It was a tale about short-term success and long-term failure. It was about doing too little and doing too much. The film covered two American figures who lobbied the US government to fund a resistance against the then-USSR’s occupying forces in Afghanistan.

Now 90 years old, Joann and her friend Charlie armed the rebels over a 10-year event known as Operation Cyclone [2]. As the conflict came to a close, an official of one of the war’s affected countries would later tell the sitting US President, “You are creating a Frankenstein.” There is always an

But Herring and Wilson’s efforts worked over the short term. They armed the rebels and those rebels won. Whether or not the fruits of their labor had a net-positive or net-negative effect on global war and peace will be left to national security experts. The relevancy of this anecdote being used is simple: the act of “arming the rebels” maintained three components over that ten-year span from 1979 to 1989: (1) tools, (2) money, and (3) psychological support.

The rebels defeated a heavily-armed Russian military machine with American tools, American money, and the promise that they had the full support of the American government. This communicated to the opposing military that the money, the tools, and the rebellion would continue. The unbeatable army was beaten by endless supply, force, and psychological warfare.

Shopify and The Arming of The Rebels

Harley Finkelstein on Twitter: “Arming the rebels @Shopify-style, a 3 step guide:1. Create a network of fulfillment centers across America 🕸️2. Allow small businesses to leverage these centers 📦3. Add in robots 🤖Result: Affordable products shipped on a two day cycle to 99% of America. 💪 pic.twitter.com/a6KIptqsbm / Twitter”

Arming the rebels @Shopify-style, a 3 step guide:1. Create a network of fulfillment centers across America 🕸️2. Allow small businesses to leverage these centers 📦3. Add in robots 🤖Result: Affordable products shipped on a two day cycle to 99% of America. 💪 pic.twitter.com/a6KIptqsbm

Shopify has done a tremendous job executing on their corporate rallying cry: We arm the rebels. Having passed Ebay to become the second-largest eCommerce ecosystem in North America, Shopify has maintained that Amazon is next – an unbeatable army in its own right. Once known solely for its role in small cap eCommerce, Shopify now services financial processing, loans, fulfillment, hardware, and an ecosystem of developers at the beck and call of merchants who can afford their services.

Shopify exists to basically arm the rebels. We want a lot of people to go out and compete against Amazon.

Tobi Lütke, founder and CEO

But what happens when you execute on two components – the tools and the money – without the psychological support? The phrase “arming the rebels”, coined by Ruby on Rails creator David Hansson in reference to Shopify’s role in a densifying eCommerce landscape [3], has a hopeful ring to it. It implies that Shopify is punching upwards (it is). But Shopify will also need to punch downwards to maintain its position.

Shopify has investors excited because it is increasingly seen as the most likely challenger to Amazon’s ecommerce dominance. While many retailers, both traditional and online, have tried to tackle Amazon’s “everything store” head-on, Shopify has succeeded by arming individual merchants with the same technology and capabilities, but with more control. [4]

Shopify’s merchants have nearly every resource at their disposal except for one. The company is slow to champion the very brands that use their platform. Out of fear of coming off as partial, Shopify has thus far hesitated to provide the one advantage that could lock brands into their ecosystem for the long term. Yes, one of three components necessary to arm the rebels: psychological support.

The Big Game Ad That Wasn’t

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I waited, fruitlessly, for Shopify’s Super Bowl advertisement. I wanted the brand to discuss – in front of the biggest audience – its evolution over time: the agencies that its ecosystem has fostered, its move into financial technologies, the DTC Era that Shopify’s invention pioneered, and the robots that will eventually fill its 3PLs.

Shopify has armed the rebels by supplying some of them with the funds necessary to operate or expand. Now, it needs to influence the demand curve for the businesses on its platforms. Shopify needs to become an evangelist for its brands.

The phrase “arming the rebels” has a hopeful ring to it. It implies that Shopify is punching upwards (it is) but will also need to punch downwards to maintain its position.

When Squarespace’s Super Bowl ad premiered, it was enough of a threat to Shopify’s market position that the company’s corporate Twitter addressed their smaller competitor in a sequence of tweets that felt somewhat out of character. Shopify is currently trading at a $54 billion market cap; Squarespace remains orders of magnitude smaller, and private.

Shopify on Twitter: “Hey, @SquareSpace we believe in supporting independent businesses too! In fact, there are over 40 businesses in #WinonaMN that are on @Shopify. So we’re going to promote as many of them as possible during the #BigGame. #WelcometoWinona #SupportingIndependents pic.twitter.com/CPq8Ld6Pgl / Twitter”

Hey, @SquareSpace we believe in supporting independent businesses too! In fact, there are over 40 businesses in #WinonaMN that are on @Shopify. So we’re going to promote as many of them as possible during the #BigGame. #WelcometoWinona #SupportingIndependents pic.twitter.com/CPq8Ld6Pgl

Given the market position that Shopify has earned, it’s become clear that Lütke’s position on psychological support must change and it should have begun with Super Bowl LIV. Shopify’s promotional power could reduce insurgent competition while closing the gap with the incumbent company that it is challenging: Amazon. Shopify must evolve into its own marketplace. As customer acquisition costs rise for small-to-middle market retailers, Amazon has become a reasonable partner for retailers looking to increase top-of-funnel awareness. From 2PM‘s A Familiar Strategy:

Amazon is harvesting consumer data to become an efficient vertical reseller. The Amazon products will continue to have the preferred place on product pages. In this way, opposing marketers’ frustrations are founded. It may be true that external brands will continue to be penalized for competing against Amazon’s private labels. The Seattle eCommerce giant seems to be preparing for a day when their data harvesting practices – a process that has spawned countless private labels – will be called into question.

Lütke’s likely opposition to this idea is clear: By selecting brands or products to feature in a marketplace format, Shopify becomes a kingmaker of sorts. A kingmaker is a person or organization with great influence on the value of a candidate. This person or organization uses policy, finance, and competitive forces to influence succession. I contend that offering loans or advancements to merchants is another form of kingmaking. Now that Shopify has begun to market financial products, there is less of an argument to be made. 

Shopify’s moat has been discussed at length: Community and the partnership ecosystem are two buzz phrases that come to mind. But the Ottawa-based SaaS company has drawn the line at promoting the businesses that support the ecosystem; the company rarely pushes traffic and media attention to the companies growing within the ecosystem.

One of the three key resources for Operation Cyclone was psychological support. In the context of Shopify’s use of the phrase, the third resource is missing. If Shopify is comfortable defending its position against Squarespace by promoting independent retailers on Twitter, their management team should also feel comfortable supporting its own marketplace.

In December 2019, Shopify.com saw nearly 47 million visitors with over 40% of the traffic coming from the United States. While official numbers have yet to be reported, the Super Bowl was viewed by over 150 million people. Situated in this audience were potential consumers who may want to start their own company, developers who may want to build for Shopify, and consumers who may want to buy from Shopify.

Amazon, Google, Microsoft, Walmart, Hulu, Quibi, Verizon, and Squarespace shelled out fees to advertise during the big game. However – direct-to-consumer brands were noticeably absent, priced out by the exorbitant costs of doing business. Imagine a $5.7 million, 30-second advertisement that sent tens of millions of Americans to marketplace.shopify.com. When those potential customers, developers, and consumers arrive: they’d see a curation of Shopify’s greatest brands – new and old, established and fresh. Shopify wouldn’t have only gained new customers or partnership prospects. Shopify would have influenced the awareness, growth, and viability for a number of brands that are dependent on three key resources.

In a June 2013 report by the Foreign Press [5], Edward Luttwak lists the five rules for arming the rebels: (1) Figure out who your friends are (2) Be prepared to do all of the work (3) Don’t give away anything that you wouldn’t want back (4) Do not invite an equal and opposite reaction by a larger power and (5) Lay groundwork for the endgame. For Shopify, that endgame involves an emphasis on demand-side economics. For the companies that rely on Shopify’s increasing suite of tools, they must thrive to remain B2B users.

By the end of that evening in Houston in 1999, I conjured up the courage to ask Herring a question or two. I was wearing my nice blue blazer, that night, so I had more confidence than usual. We learned about Operation Cyclone from an alum of the school in one of our courses but it wasn’t yet a widely known story. So on that night, I felt privileged to speak with her before her answers would be honed by Madison Avenue public relations spinmasters. I asked Ms. Herring the type of simple question that a 16-year-old student would: “What did you learn from it all?” She replied with something to the effect of, “We should have given them more and faster. It all dragged on too long. We could have done 10 years’ work in three or four.”

When you arm the rebels, do whatever you can to make sure that they win. They’re fighting for their supplier as much as they’re fighting for their own well-being. After all, their war is now your war.

Read the No. 345 edition here.

Report by Web Smith, Edited by Hilary Milnes | About 2PM