Netflix disrupted the Cable companies - now it's being disrupted by the Cable companies

Diary entry #2

There are historically 3 parties in the TV supply chain. The producers of the show at the top, the cable companies in the middle, and the distributors at the bottom.

Show Producers make money by selling rights of their show to cable companies. Cable companies aggregate the hundreds of shows into channels, then aggregate hundreds of channels into bundles, and on-sell the bundles to distributors (e.g. ESPN, CNN, Discovery & Disney Channel for $99/month); as well as include advertisements in between shows. Distributors then figure out how to get the show + ads to viewers (DVD, satellite, fibre, etc).

As bundling became more popular, cable companies who by the 1990's had already consolidated into a few big players (e.g. Comcast, AT&T, TCI), held immense bargaining power over both producers (suppliers) and distributors (buyers). Also it was incredibly capital intensive to lay out new cable infrastructure, vs the relatively lower capital intensity of show producers and distributors, hence much higher barriers to entry to become an aggregator.

Then the cable companies started moving upstream, by acquiring producers (e.g. Disney acquire Fox, Comcast acquire NBC); and by virtue of being cable companies were also the de facto downstream channel (after satellite and Napster both lost the war to cable). The upstream movement is important, because nearly all viewing time is spent on maybe <100 "hit" shows; so if you owned the network which made that hit show (e.g. Friends), you owned nearly all the profits of that genre because you could rent that show out to other cable companies.

So you ended up with a few cable companies controlling the entire sector to the point that most of the TV industry was referred to as 'cable' - it was a total oligopoly. That's why you always hear people complaining about how cable companies suck, because they raise prices every year but never upgrade to their infrastructure (slow speeds especially in rural areas). It was an incredible business model.




In 2011, Google Fiber entered the scene and tried to replace cable with fibre (which was much faster than cable). The idea was the same, own all 3 parts of the supply chain and become a much faster cable company. The idea was good, because they had infinite capital from their Search business that they could reinvest into fibre, and it would be prohibitively expensive for the existing cable incumbents to rewire all their cable into fibre.

Unfortunately due to difficult regulatory headwinds, Google Fiber ultimately failed. But then Netflix started becaming prominent on the scene. Its streaming "pay-only-what-you-watch" model disrupted a different part of the supply chain, bundling - the bread & butter of the aggregators. Without bundling, the entire business model of the cable companies fell apart. You can't make enough money from a single channel to keep paying for premium content (e.g. live NBA basketball for ESPN), if the only people paying for it are the people who watch it. As more people switched from bundling to unbundling, streaming became popular and cable fell to the wayside.

Now the same thing is happening to streaming. Even though cable has been commoditized into a data pipe, the cable companies by virtue of moving upstream still own all the hit shows. The question was never whether cable companies would enter streaming; it was whether they were willing to cannibalize their own cable subscriptions. As cable became less and less lucrative, it made financial sense to enter streaming themselves.




When Netflix started, it bought long-term show rights to all the hit shows to fill its inventory. They realized the rights would expire eventually, which was why they started Original Content to mimic the upstream part of the supply chain, beginning with House of Cards in 2013. So they've had roughly a 10-year headstart in building their own upstream inventory before their show rights expired.

But now the rights have finally started expiring. Going forward, you will begin to see the cable companies pull all their hit shows from the new streaming services, in favor of their own streaming services which primarily make money from ads. As Netflix's inventory of hit shows deplete, it becomes less able to justify charging monthly subscriptions when everyone else is able to watch their old hit shows for free with ads on competitor's streaming sites. So the cable companies are just returning tit-for-tat - they are targeting Netflix's bread and butter (i.e. pay only for what you watch) by offering an ad-driven model (i.e. don't pay for anything to watch everything). Eventually, with less hit shows on inventory, the new streaming services won’t be able to justify unbundling (e.g. not many people watch anime, even if you have plenty of it); as with less hit shows that people want to watch, they can no longer only charge for what you want to watch - i.e. they will need to go back to bundling (pay for even what you don't watch), or become an ad-driven service.

This is why Disney+ has an advantage among the new streaming services – not only does it have a huge inventory of shows from the Disney Channel for kids (plonk your kid in front of a TV for 3 hours while you do house chores) to serve as a cash cow, it owns many movie studios and can bring its movies to streaming (e.g. Mulan). Furthermore, it could potentially merge with Hulu (which is majority-owned by Disney) to serve currently running shows, most of which are on Hulu. If nothing changes, Netflix will eventually be in a similar position to Apple TV+ today – plenty of capital (i.e. potential hit shows) but no actual hit shows of its own. That’s what the Original Content is for – long-term royalties from re-runs after the long-term show rights expire.




So now Netflix has for all practical purposes become a cable company in its own right. The question is can it justify its lofty valuation when those show rights expire and churn rates start to increase, especially as competitors are running on an ad-driven model (i.e. infinite staying power). For sure they will no longer be able to keep raising prices every year like clockwork as they have for the past decade.

Personally, I will no longer be relying on Netflix after NBC pulled Parks & Recreation and moved it to Peacock, their new streaming service. I may continue paying for Netflix because it’s still affordable, but I may change my mind later if they raise prices when I don’t really watch my favorite shows on it anymore. Also, you’re probably going to see more “leapfrogs” going forward – people who subscribe to one streaming service to binge-watch all seasons of an entire old show in one month, then cancel the subscription (that's what people are doing to Game of Thrones on HBO Max now).

So the lynchpin of the entire business model boils down to one thing – new hit shows. Because if you’re subscribed to a currently running show (e.g. The Mandalorian), you can't leapfrog since new episodes keep coming out. That’s what gave HBO Go staying power while Game of Thrones was airing, and why Mandalorian will give Disney+ staying power for awhile. Unfortunately, Netflix doesn’t own a currently running mainstream show of its own at this time, and its position is becoming increasingly precarious just as Apple TV+'s is.

Further reading:

The Disruption of Netflix: A Plan for its Survival - https://www.digitalcenter.org/columns/netflix-rough-times/