Netflix’s moment of greatest peril is, in retrospect, barely visible in the company’s stock chart:

I’m referring to 2004-2007 and the company’s battle with Blockbuster:

The simplified story of Netflix’s founding starts with Reed Hastings grumbling over a $40 late charge from Blockbuster, and ends with the brick-and-mortar giant going bankrupt as customers came to prefer online rentals from Netflix, with streaming providing the final coup de grâce.

Neither are quite right.

The Blockbuster Fight

Netflix was the idea of Marc Randolph, Netflix’s actual founder and first CEO; Randolph was eager to do something in e-commerce, and it was the just-emerging DVD form factor that sold Hastings on the idea. He would fund Randolph’s new company and be chairman, eventually taking over as CEO once he determined that Randolph was not up to the task of scaling the new company.

Blockbuster, meanwhile, mounted a far more serious challenge to Netflix than many people remember; the company started with Blockbuster Online, an entity that was completely separate from Blockbuster’s retail business for reasons of both technology and culture: Blockbuster’s stores were not even connected to the Internet, and store managers and franchisees hated having an online service cannibalize their sales. Still, when a test version went live on July 15, 2004 — the same day as Netflix’s quarterly earnings call — Netflix’s stock suffered its first Blockbuster-inspired plunge.

Three months later Netflix cut prices and referred to Amazon’s assumed imminent entry to the space; Netflix’s stock slid again. Hastings, though, said the increased competition and looming price war was actually a good thing. Gina Keating relayed Hastings’ view on that quarter’s earnings call in Netflixed:

“Look, everyone, I know the Amazon entry is a bitter and surprising pill for those of you that are long in our stock,” he told investors on the earnings conference call. “This is going to be a very large market, and we’re going to execute very hard to make this back for our shareholders, including ourselves.” The $8 billion in U.S. store rentals would pour into online rentals, setting off a grab for subscribers, he said. The ensuing growth of online rentals would cannibalize video stores faster and faster, until they collapsed. As video store revenue dropped sharply, Blockbuster would struggle to fund its online operation, he concluded. “The prize is huge, the stakes high, and we intend to win.”

Blockbuster responded by pricing Blockbuster Online 50 cents cheaper, accelerating Netflix’s stock slide. Netflix, though, knew that Blockbuster was carrying $1 billion in debt from its spin-off from Viacom, and decided to wait it out; Blockbuster cut the price again, taking an increasing share of new subscribers, and still Netflix waited. Again from Keating:

Hastings agonized over whether to drop prices further to meet Blockbuster’s $14.99 holiday price cut, but McCarthy steadfastly objected. With Blockbuster losing even more on every subscriber, relief from its advertising juggernaut was even closer at hand. Kirincich checked his models again—and the outcome was the same. Blockbuster would have to raise prices by summertime. Because Netflix was still growing solidly, McCarthy wanted to sit tight and wait until the inevitable happened. “They can continue to bleed at this rate of $14.99, given the usage patterns that we know exist early in the life of the customer, until the end of the second quarter,” Kirincich told the executives.

Netflix was right:

By summertime [Blockbuster CEO John Antioco could no longer shield the online program from the company’s financial difficulties. Blockbuster’s financial crisis unfolded just as McCarthy and Kirincich’s models had predicted. The year’s DVD releases had performed woefully so far, and box office revenue — a fair indicator of rental revenue — was down by 5 percent over 2004. It was clear that Blockbuster would miss its earnings targets, meaning that it was in danger of violating its debt covenants. Antioco directed Zine to again press Blockbuster’s creditors for relaxed repayment terms, and broke the news to Evangelist that he would have to suspend marketing spending for a few months, and possibly raise prices to match Netflix’s…

The flood of marketing dollars that Antioco had committed to Blockbuster Online was crucial to keeping subscriber growth clicking along at record rates, and Cooper feared that cutting off that lifeblood would stop the momentum in its tracks. He was disappointed to be right. The result of the deep cuts to marketing was the same as letting up on a throttle. New subscriber additions barely kept up with cancellations, leaving Blockbuster Online treading water after a few weeks. While Netflix had zoomed past three million subscribers in March, Blockbuster had to abandon its goal of signing up two million by year’s end.

Still, Netflix wasn’t yet out of the woods: in 2006 Blockbuster launched Total Access, which let subscribers rent from either online or Blockbuster stores; the stores were still not connected to the Internet, so subscribers received an in-store rental in exchange for returning their online rental, which also triggered a new online rental to be sent to them. In other words, they were getting two rentals every time they visited a store. Customers loved it; Keating again:

Nearly a million new subscribers joined Blockbuster Online in the two months after Total Access launched, and market research showed consumer opinion nearly unanimous on one important point — the promotion was better than anything Netflix had to offer. Hastings figured he had three months before public awareness of Total Access began to pull in 100 percent of new online subscribers to Blockbuster Online, and even to lure away some of Neflix’s loyal subscribers. Hastings had derided Blockbuster Online as “technologically inferior” to Netflix in conversations with Wall Street financial analysts and journalists, and he was right. But the young, hard-driving MBAs running Blockbuster Online from a Dallas warehouse had found the one thing that trumped elegant technology with American consumers — a great bargain.

His momentary and grudging admiration for Antioco for finally figuring out how to use his seven thousand–plus stores to promote Blockbuster Online had turned to panic. The winter holidays, when Netflix normally enjoyed robust growth, turned sour, as Hastings and his executive team—McCarthy, Kilgore, Ross, and chief technology officer Neil Hunt—pondered countermoves.

Netflix would go on to offer to buy Blockbuster Online; Antioco turned the company down, assuming he could get a better price once Netflix’s growth turned upside down. Carl Icahn, though, who owned a major chunk of Blockbuster and had long feuded with Antioco, finally convinced him to resign that very same quarter; Antioco’s replacement took money away from Total Access and funneled it back to the stores, and Netflix escaped (Hastings would later tell Shane Evangelist, the head of Blockbuster Online, that Blockbuster had Netflix in checkmate). Blockbuster went bankrupt two years later.

Netflix’s Competition

I suspect, for the record, that Hastings overstated the situation just a tad; his admission to Evangelist sounds like the words of a gracious winner. The fact of the matter is that Netflix’s analysis of Blockbuster was correct: giving movies away was a great way to grow the business, but a completely unsustainable approach for a company saddled with debt whose core business was in secular decline — thanks in large part to Netflix.

Still, the fact remains that Q2 2007 was one of the few quarters that Netflix ever lost subscribers; it would happen again in 2011, but that would be it until last year, when Netflix’s user base declined two quarters in a row. This time, though, Netflix wasn’t the upstart fighting the brand everyone recognized; it was the dominant player, facing the prospect of saturation and stiff competition as everyone in Hollywood jumped into streaming.

What was surprising at the time was how surprised Netflix itself seemed to be; this is how the company opened the 1Q 2022 Letter to Shareholders:

Our revenue growth has slowed considerably as our results and forecast below show. Streaming is winning over linear, as we predicted, and Netflix titles are very popular globally. However, our relatively high household penetration – when including the large number of households sharing accounts – combined with competition, is creating revenue growth headwinds. The big COVID boost to streaming obscured the picture until recently.

That Netflix would soon be facing saturation was in fact apparent for years; it also shouldn’t have been a surprise that competition from other streaming services, which Netflix finally admitted existed in that same shareholder letter, would be a challenge, at least in the short-term. I wrote in a 2019 Daily Update:

That is not to say that this miss is not reason for concern: Netflix growing into its valuation depends on both increasing subscribers and increasing price, and this last quarter (again) suggests that the former is not inevitable and that the latter is not without cost. And yes, while Netflix may have not yet lost popular shows like Friends and The Office, both were reasons for subscribers to stick around; their exit will make retention in particular that much more difficult.

That will put more pressure on Netflix’s original content: not only must it attract new users, it also has to retain old ones — at least for now. I do think this will be a challenge: I wouldn’t be surprised if the next five years or so are much more challenging for Netflix as far as subscriber growth, and there may very well be a lot of volatility in the stock price (which, to be fair, has always been the case with Netflix).

COVID screwed up the timing: everyone being stuck at home re-ignited Netflix subscriber growth, but the underlying challenges remained, and hit all at once over the last year. That same Daily Update, though, ended with a note of optimism:

Note that time horizon though: as I have argued at multiple points I believe there will be a shakeout in streaming; most content companies simply don’t have the business model or stomach for building a sustainable streaming service, and will eventually go back to licensing their content to the highest bidder, and there Netflix has a massive advantage thanks to the user base it already has. To use an entertainment industry analogy, we are entering the time period of The Empire Strikes Back, but the big difference is that it is Netflix that owns the Death Star.

Fast forward to last fall’s earnings, and Netflix seemed to have arrived at the same conclusion; my biggest takeaway from the company’s pronouncements was the confidence on display, and the reason called back to the battle with Blockbuster. From the company’s Letter to Shareholders:

As it’s become clear that streaming is the future of entertainment, our competitors – including media companies and tech players – are investing billions of dollars to scale their new services. But it’s hard to build a large and profitable streaming business – our best estimate is that all of these competitors are losing money on streaming, with aggregate annual direct operating losses this year alone that could be well in excess of $10 billion, compared with our +$5-$6 billion of annual operating profit. For incumbent entertainment companies, this high level of investment is understandable given the accelerating decline of linear TV, which currently generates the bulk of their profit.

Ultimately though, we believe some of our competitors will seek to build sustainable, profitable businesses in streaming – either on their own or through continued industry consolidation. While it’s early days, we’re starting to see this increased profit focus – with some raising prices for their streaming services, some reigning in content spending, and some retrenching around traditional operating models which may dilute their direct-to-consumer offering. Amidst this formidable, diverse set of competitors, we believe our focus as a pure-play streaming business is an advantage. Our aim remains to be the first choice in entertainment, and to continue to build an amazingly successful and profitable business.

The fact that Netflix is now profitable — and, more importantly, generating positive free cash flow — wasn’t the only reason for optimism: Netflix had the good fortune of funding its expansion into content production in the most favorable interest rate environment imaginable; Netflix noted in this past quarter’s Letter to Shareholders:

We don’t have any scheduled debt maturities in FY23 and only $400M of debt maturities in FY24. All of our debt is fixed rate.

That debt totals $14 billion; Warner Bros. Discovery, meanwhile, has $50.4 billion in debt, Disney has $45 billion, Paramount has $15.6 billion, and Comcast, the owner of Peacock, has $90 billion. None of them — again, in contrast to Netflix — are making money on streaming, and cash flow is negative. Moreover, like Blockbuster and renting DVDs from stores, the actual profitable parts of their businesses are shrinking, thanks to the streaming revolution that Netflix pioneered.

Warner Bros. Discovery and Disney are almost certainly pot-committed to streaming, but Warner Bros. Discovery in particular has talked about the importance of profitability, and Disney just brought back Bob Iger after massive streaming losses helped doom his predecessor née successor; it seems likely their competitive threat will decrease, either because of higher prices, less aggressive bidding for content, or both. Meanwhile, it’s still not clear to me why Paramount+ and Peacock exist; perhaps they will not, sooner rather than later.

When and if that happens Netflix will be ready to stream their content, at a price that makes sense for Netflix, and not a penny more.

Netflix’s Creativity Imperative

That’s not to say that everything at Netflix is rosy: the other thing that was striking about the company’s earnings last week was the degree to which management gave credence to various aspects of the bear case against the company.

First, Netflix gets less leverage off of its international content than it once hoped for. One of the bullish arguments for Netflix is that it could create content in one part of the world and then stream it elsewhere, and while that is true technically, it doesn’t really move the needle in terms of engagement. Co-CEO Ted Sarandos said on last week’s earnings interview:

Watching where viewing is growing and where it’s suffering and where we are under programming and over programming around the world is a big task of the job. Spence and his team support Bella and her team in making those allocations, figuring out between film and television, between local language — and what’s really interesting is there aren’t that many global hits, meaning that everyone in the world watches the same thing. Squid Game was very rare in that way. And Wednesday looks like one of those too, very rare in that way. There are countries like Japan, as an example, or even Mexico that have a real preference for local content, even when we have our big local hits.

This means that Netflix has less leverage that you might think, and that said leverage varies by market; to put it another way, the company spends a lot on content, but that spend is distributed much more than people like me once theorized it might be.

Second, Netflix gets less value from its older content than bulls once assumed — or than its amortization schedule suggests (which is why the company’s profit number is misleading). Sarandos said in response to a question about how Netflix would manage churn in the face of cracking down on account sharing and raising prices:

I would just say that it’s the must-seeness of the content that will make the paid sharing initiative work. That will make the advertising launch work, that will make continuing to grow revenue work. And so it’s across film, across television. It’s the content that people must see and then it’s on Netflix that gives us the ability to do that. And we’re super proud of the team and their ability to keep delivering on that month in and month out and quarter in and quarter out and continuing to grow in all these different market segments that our consumers really care about. So that, to me, is core to all these initiatives working, and we’ve got the wind at our back on that right now.

If Netflix’s old content held its value in the way I once assumed then you could make a case that the company’s customer acquisition costs were actually decreasing over time as the value of its offering increased; it turns out, though, that Netflix gets and keeps customers with new shows that people talk about, while most of its old content is ignored (and perhaps ought be monetized on services like Roku and other free ad-supported TV networks).

From Spock to Kirk

Reed Hastings has certainly earned the right to step up — and back — to executive chairman; last Thursday was his last earnings interview. It’s interesting, though, to go back to his initial move from chairman to the CEO role. Randolph writes in the first chapter of his book That Will Never Work:

Behind his back, I’ve heard people compare Reed to Spock. I don’t think they mean it as a compliment, but they should. In Star Trek, Spock is almost always right. And Reed is, too. If he thinks something won’t work, it probably won’t.

Unfortunately for Randolph, it didn’t take long for Spock to evaluate his performance as CEO; Randolph recounted the conversation:

“Marc,” Reed said, “we’re headed for trouble, and I want you to recognize as a shareholder that there is enough smoke at this small business size that fire at a larger size is likely. Ours is an execution play. We have to move fast and almost flawlessly. The competition will be direct and strong. Yahoo! went from a grad school project to a six-billion-dollar company on awesome execution. We have to do the same thing. I’m not sure we can if you’re the only one in charge.”

He paused, then looked down, as if trying to gain the strength to do something difficult. He looked up again, right at me. I remember thinking: He’s looking me in the eye. “So I think the best possible outcome would be if I joined the company full-time and we ran it together. Me as CEO, you as president.”

Things changed quickly; Keating writes:

Hastings now held Netflix’s reins firmly in hand, and the VC money gave him the power to begin shifting the company’s culture away from Randolph’s family of creators toward a top-down organization led by executives with proven corporate records and, preferably, strong engineering and mathematics backgrounds.

Randolph ultimately left the company in 2002; again from Keating:

The last year or so of Randolph’s career at Netflix was a time of indecision — stay or go? He had resigned from the board of directors before the IPO, in part so that investors would not view his desire to cash out some of his equity as a vote of no confidence in the newly public company. Randolph landed in product development while trying to find a role for himself at Netflix, and dove into Lowe’s kiosk project and a video-streaming application that the engineers were beginning to develop. But after seven years of lavishing time and attention on his start-up, Randolph needed a break. Netflix had changed around him, from his collective of dreamers trying to change the world into Hastings’ hypercompetitive team of engineers and right-brained marketers whose skills intimidated him slightly. He no longer fit in.

To say that Hastings excelled at execution is a dramatic understatement; indeed, the speed with which the company rolled out its advertising product in 2022 (better late than never) is a testament that Hastings’ imprint on the company’s ability to execute remains. And again, that ability to execute was essential for much of Hastings tenure, particularly when Netflix was shipping DVDs: acquiring customers efficiently and delivering them what was essentially a commodity product was all about execution, as was the initial buildout of Netflix’s streaming service.

What is notable, though, is that the chief task for Netflix going forward is not necessarily execution, at least in terms of product or technology. While Hastings has left Netflix in a very good spot relative to its competitors, the long-term success of the company will ultimately be about creativity. Specifically, can Netflix produce compelling content at scale? Matthew Ball observed in a Stratechery Interview last summer:

Netflix is, in some regard, a sobering story. What do I mean by that? First mover advantages matter a lot, scale matters a lot, their product and technology investments matter a lot. Reed [Hastings] saw the future for global content services and scale that span every market, every genre, every person, truly years before any competitor did. I think we see pretty intense competition right now, but it’s remarkable when you actually look at the corporate histories of all of the competitors, most have changed leadership at the CEO level twice, at the DTC level three to four times, Hulu is on its fifth or sixth CEO and so we have to give incredible plaudits to all of that.

Yet what I find so important here, is at the end of the day, all of those things only matter for a while. Content matters, that’s the product that they’re selling, it’s entertainment. The thing that has surprised me most about Netflix is their struggles to get better at it. When I was at Amazon Studios and we were competing with them day in and day out, the assumption you would’ve made in 2015, ’16, ’17 would be that the Netflix of 2022 would be much better at making content than it seems to be. That their batting average would be much higher. Why? Because they’ve spent $70 or $80 billion since and I think we’re starting to feel the consequences of [not being as far ahead as expected].

It’s impossible to not dive into the history of Netflix and not come away with a deep appreciation for everything Hastings accomplished. I’m not sure there is any company of Netflix’s size that has ever been so frequently doubted and written off. To have built it to a state where simply having the best content is paramount is a massive triumph. And that, perhaps, is another way of saying that Spock’s job is finished: Netflix’s future is about creativity and humanity; it’s time for a Captain Kirk.