Saving Hollywood With One Hand, Kicking It While It's Down With the Other: How Netflix Remade Entertainment With Global Distribution

Netflix has told a lot of stories about technology, but what matters most is distribution.

"It depends on where you stand. You either think Netflix is saving Hollywood, or you think it's kicking an industry that's already on shaky ground while it's down." That's how an article in Variety described the relationship between Netflix and Hollywood last year.

The internet may be everywhere, but Netflix is still the first technology company since television to break into the entertainment business and change it.

The case for Netflix saving Hollywood: it spends billions of dollars a year on film and television content, and it has pulled Amazon and Apple into eyeing this new market alongside it.

Once that money flows in, it ends up right back with the producers, directors and actors who have always made up traditional Hollywood. Netflix brought in the Coen brothers to direct and Will Smith to star in a series; Amazon got Woody Allen to make a show. At this year's Oscars, Netflix picked up eight nominations.

Then there is Shonda Rhimes, the producer behind Grey's Anatomy, whom Netflix poached — her previous job was at Disney-owned ABC.

From the Emmys to the Golden Globes to the Oscars, from nominees to winners, the best shows and the best people have ended up in productions paid for by internet companies. For Hollywood, working with Netflix means the most effective television distribution there is — a show can launch in multiple global markets at once. That was unimaginable in the era of cable television and movie theaters.

That channel is so powerful that Netflix CEO Reed Hastings has said his rivals include his users' sleep.

But the same channel is also killing Hollywood.

The five big Hollywood studios — Disney, Time Warner, 21st Century Fox, Sony and Paramount — made a combined profit of just $4.17 billion in 2017, down 77% from a decade earlier — less than Time Warner alone made back then.

At some studios, the film division now accounts for less than 10% of the parent company's total profit. Some forecasts put that share falling to around 5%.

U.S. movie theater attendance has hit a 19-year low, with annual box office revenue just past $10 billion. That $10 billion is roughly what Netflix added to its market value in five trading days last week.

"Because of its overreliance on franchises, Hollywood has ceded most of the edgier films to pay-TV providers like HBO and Showtime, and to digital-native platforms like Netflix and Amazon," Vanity Fair wrote.

Having got this far, Netflix is the first technology company since film and television themselves to truly break into the entertainment business, and it has grown into an opponent every Hollywood giant fears. Apple, so often praised for changing the music business, only changed how music and albums were priced and marketed through iTunes; it never touched how the content was made.

Whether all this turns out to be good or bad for Hollywood, Netflix looks to be on a path that is good for Netflix.

According to the earnings report Netflix released last week, more than 120 million people around the world now pay it every month, its operating profit has doubled to $800 million, and its international business turned an annual profit for the first time.

The results beat Wall Street's expectations. In the five days after the report, Netflix's market value rose by $17.6 billion, to nearly $120 billion — twice that of 21st Century Fox, and 30% more than all of Baidu.

Disney, the biggest studio in Hollywood, with Marvel, Star Wars and Pixar, cut off its lucrative licensing deal with Netflix in August 2017, ending U.S. licensing of Disney-branded content, and launched two Netflix-like services of its own.

As for Netflix's peers in tech — Google, Apple and Facebook — they are pushing hard into Hollywood, preparing to spend billions of dollars on original programming, as Amazon did before them. And the company Amazon copied was Netflix.

Here are 11 charts showing how Netflix, with its enormous distribution channel, is changing Hollywood.

Netflix has told the story of making shows with big data, but that matters far less than its distribution

Mining user behavior with big data, defining a recommendation system with multiple algorithms, building a content library tailored to users — these have been Netflix's talking points for years whenever it calls itself a technology company.

The example most often cited is House of Cards. By Netflix's account, it looked at what users saved, what they were recommended, what they replayed, what they paused and what they searched for, and predicted that a series combining Kevin Spacey, David Fincher and a "BBC production" pedigree would be a hit. Spacey was the lead; Fincher directed the first season.

But you do not need big data to decide that a series starring an Oscar-winning actor, directed by a famous Hollywood filmmaker who has worked in television, and adapted from a script already tested in Britain, might do well. That is no different from Paramount, which has no big data, hiring Michael Bay year after year to make Transformers films for Chinese audiences.

None of this has much to do with big data. A powerful distribution channel is Netflix's most important and most central asset.

Starting from its DVD rental business, Netflix won a large user base by offering an experience the services of the day could not match — rentals with no due date, and a huge catalog of titles.

Those users then became the starting users for Netflix's streaming business. Netflix used its ample cash flow to buy and produce large amounts of film and TV content, which brought in more users.

Among the four biggest online video companies in the U.S., Netflix charges from $7.99 a month up to $13.99, with no advertising. Every tier of subscriber gets the same terms: pay the first month, cancel any time after that, unlimited films and shows, and viewing across multiple devices and screens. The only thing the price changes is video resolution.

Netflix used technology to serve customers through a business model incumbents could not compete with, then moved up the value chain over time — until those competitors, with worse service at higher prices, were disrupted.

By the end of 2017, the U.S. had 120 million households, and more than 40% of them were paying Netflix subscribers — more than the combined subscriber count of the country's five biggest cable networks.

It has no news and little sports, but Netflix itself has effectively become a giant theater chain or a cable network.

In 2017, Netflix proved the channel it built in the U.S. could be copied worldwide

Netflix's international journey began in 2010, when it entered Canada. From there it moved into Latin America, the U.K., Finland, Germany and more, and in January 2016 it announced it was entering every market in the world except China and a handful of other countries and regions.

Before a new market can return anything, Netflix has to advertise locally and build a local team — a process it repeats almost every time it enters a new market.

That heavy upfront spending meant that in the early years, losses in Netflix's international business ran to 2.3 times its revenue. But the international business was expanding fast in that period: new-subscriber growth once hit 220% year over year, and it has stayed above 40% a quarter since.

Brazil is Netflix's largest overseas market. A 2017 survey by RBC Capital found that 77% of Brazilian respondents had watched Netflix. Of those, 90% said they were very satisfied, and 66% said they would "never cancel."

Augusto, a Brazilian subscriber, told QDaily that Netflix is far cheaper than Brazilian cable: his parents' home has cable on two televisions for $45 a month, while he pays about $11 a month to watch Netflix in ultra-high definition on four devices.

"As I remember it, most young Brazilians choose Netflix because once you pay the monthly fee you can watch whatever you want, with no ads and no limit on how many times or how long you watch. We pretty much only go to cable for football; the rest of the time it's Netflix or YouTube. Our parents' generation is more traditional — they go with cable," Augusto said, which sounds no different from Americans.

Even as international expansion began to pay off, Netflix ran into Wall Street in July 2016: in that second quarter it added only 1.7 million subscribers, below Wall Street's forecast of 2.5 million. After the report, the stock fell as much as 16%.

Fast-growing international subscribers were the only good news at the time, accounting for 90% of that quarter's global additions. International growth is still helping Netflix now.

On last week's earnings call, Netflix CEO Reed Hastings acknowledged that with domestic U.S. growth slowing, international subscribers drove most of the company's growth for all of 2017 — reaching 63 million in total, already more than the U.S. base.

Beyond subscriber counts, international streaming revenue has risen as a share of total revenue every year, while the loss rate has narrowed. In 2017, nearly half of Netflix's revenue — about $5 billion — came from international operations, which turned an annual profit for the first time: $220 million.

That put Wall Street's doubts to rest, and Netflix's stock rose for four straight days.

After using mainstream American content to open markets, Netflix started making local content too

When Netflix switched on its service around the world in early 2016, the common view was that it could easily reach into the U.K. and other wealthy European countries, where English is widely spoken.

In other markets, growth was in doubt, for all sorts of reasons: pricing models, cultural differences in taste in film and television, and how well localization — subtitle translation, for one — would be handled in non-English-speaking countries and regions. And China, a market that matters to almost any product, has kept Netflix shut out.

Netflix has still found its way into overseas markets. In Japan, it has bought rights to popular Japanese IP on one hand and worked with Japanese companies such as Yoshimoto Kogyo on the other, adapting the award-winning, best-selling local novel Spark (《花火》) into a series. Netflix also casts internationally known local talent to draw bigger audiences: Spark was directed by Ryuichi Hiroki, with a cast including Kento Hayashi and Kazuki Namioka.

In Brazil, Augusto remembers that Netflix captured most of its early users with Breaking Bad when the service arrived in 2011. But what really made Netflix take off there was Narcos, the hit series about the lives of South American drug traffickers, which cast a Brazilian actor as Pablo Escobar in the first season.

Last November, Netflix raised two of its monthly plans by $1 and $2. Spread across each subscriber that is small change, but added up it means at least 10% more revenue. Netflix said the money would keep going toward growing international subscriptions and producing original series.

By Netflix's latest account, penetration is rising sharply in markets including India and Indonesia and elsewhere in Southeast Asia — "much like the first few years of the Latin America rollout." Hastings added that strong localization of new shows is pushing international subscriber growth further.

In South Korea, for instance, Netflix will release an original Korean drama this year called Kingdom, directed by Kim Seong-hun (Tunnel, A Hard Day), written by Kim Eun-hee (the screenwriter of Signal), with Bae Doona in the lead. All of them are household names in Korea.

Netflix's original plans in Korea go beyond drama. Last September it announced it would produce the Korean variety show Busted!, bringing in Jo Hyo-jin and Kim Joo-hyung, the producers behind the popular variety shows Running Man and Family Outing.

With 80 films a year, Netflix has become the most prolific film producer in the U.S.

Counting from House of Cards in 2013, Netflix has kept raising what it spends on original content. The main point is to shake off its dependence on Hollywood studios and other content suppliers.

From the autumn of 2015, after Netflix failed to reach a deal with the film channel Epix, a large amount of non-exclusive content came off the service. By March of the following year, Netflix's streaming library was 26% smaller than two years earlier. That pushed Netflix to put more effort into exclusive content.

From 2014 to 2016, Netflix's spending on original series rose by $1.5 billion a year, reaching $6 billion in 2016. Shows it made, such as The Get Down and Sense8, cost nearly $10 million an episode. Among its rivals, only Amazon has kept up that pace of spending.

This year Netflix expects to put out 80 original films, all released within the year. That works out to a new film every four and a half days. Warner Bros., Hollywood's most prolific studio, released 23 films in 2016.

Hollywood routinely spends hundreds of millions of dollars on a single film, then nearly as much again on advertising, and splits the take with theater chains. Netflix works differently: most of its planned 80 films will be low-budget productions costing under $10 million each.

Hollywood makes its money on expensive films and relies on smaller ones to promote projects and keep its relationships with distributors warm. Because a big investment carries big risk, studios often make their films to a template; a franchise cuts the cost of teaching the market something new. Marvel's Iron Man, Thor and Doctor Strange all came out of the same mold. Reusing a successful template reduces risk, but it also kills creativity.

Netflix has taken another route, one that plays to its biggest advantage: unlimited room to store content, a platform to show it on, and more than 100 million paying subscribers already in hand. In 2016, North America saw an average of 10 new films released a week; on Netflix, viewers could reach more than five times that. Sitting on the couch or lying in bed, they open a phone, tablet, computer or television — whichever is closest — and watch.

Along the way, Netflix has also changed how audiences watch television.

Instead of the traditional network model — order a pilot, test it, order a full season, air it weekly, then decide whether to renew — Netflix orders and releases a whole season at once, so subscribers can start a marathon the day it goes up.

This way of watching is called binge-watching.

A Netflix survey found that even then, 61% of respondents said they often binge-watch, and 73% said long binges on streaming platforms made them feel good.

And because a whole season is made and then released, writing and shooting are more continuous. Creators no longer have to adjust week by week to audience feedback, as they once did; they hold the direction of the story themselves.

Asked why the company was doing more television, David Glasser, chief operating officer of The Weinstein Company, said: "We now have the ability to take a traditional documentary and stretch it to four hours, six hours, even eight hours. You can really get inside a story."

Jenji Kohan, the creator of Orange Is the New Black, Netflix's most-watched original series, pointed to another effect of working a season at a time. She said the show can let a plotline wander off, and it does not matter if a major character disappears for a while, because the audience is binge-watching and will see that character again a few hours later. That would be hard in a traditional weekly show, where the lead has to appear in every episode or viewers get confused.

All of this has turned Netflix into a machine for wringing time out of its users.

As early as 2014, Netflix was winning more of American viewers' time. Data compiled by Redef shows that U.S. Netflix users watched about 130 billion minutes of video a month that year, more than a number of traditional television giants including Discovery, Disney's cable networks and NBCUniversal's cable networks.

Hollywood's own channels are fighting back, but the West Coast tech companies look like the better bet

HBO, squarely in the "Hollywood camp," is itself a paid cable channel. Once streaming video took off, it joined in.

In the early days, to avoid eating into its core network business, HBO split its streaming into two products, HBO NOW and HBO GO. Both let subscribers watch everything HBO airs — films, series, sports and variety programming — across multiple devices and screens, with premieres available the same day they go out on television.

But the first can only be watched on streaming; to watch on a television as well, you pay another $75 a month. That gave HBO a service priced on a par with cable and satellite TV, and twice as expensive as other video services.

HBO's early streaming product was also just bad. When the network was poor, HBO did not lower the resolution to keep playback smooth — it cut the picture entirely and left subscribers with sound.

The company catching up to Netflix fastest is still Amazon. It not only spends billions of dollars a year on its own content; it also has more than 50 million people in the U.S. who signed up for Prime for one reason or another, each paying Amazon at least $99 a year, even if many of them first joined to skip shipping fees.

At the same time, Amazon is courting traditional television networks, letting viewers pay an extra monthly fee to subscribe to other channels' programming.

Hollywood's content business is already adapting to the changes Netflix brought — which is not necessarily good news

Hollywood films have a "release window," the gap between a film's theatrical run and the release of its digital and home-video versions. The model is how studios and distributors maximize their take: a long window lets a film earn in stages over a long period, squeezing out its full commercial value.

But from 2005 to 2016, the average time from theatrical release to paid video kept falling. Between 2015 and 2017 it dropped fast, from an average of 135 days to 45.

In that period Netflix also tried to release its own films in theaters and on its site at the same time, which Hollywood likewise opposed. John Fithian, president of the National Association of Theatre Owners, issued a statement warning Netflix that the practice would cut both theatrical and online revenue.

Now, though, it is Hollywood's big studios that want a shorter window. 20th Century Fox thinks 30 to 45 days after theatrical release is about right before a film goes to video sites, while the more aggressive Universal Pictures and Warner Bros. think the window could be cut to 20 days and 17 days.

The reason for the change of heart: power in Hollywood has shifted. In the past these studios held not only the best content but also the distribution — television networks, DVD distribution, even theaters — which is why they set the rules the whole industry ran by.

Now internet channels they do not control have risen and begun to challenge those rules, without having to share revenue with them. What makes it impossible for Hollywood to refuse the internet companies is that the money they can offer beyond the box office keeps growing.

In all of 2016, North American box office revenue was $11.377 billion, only 2.2% more than in 2015. Over the same period, streaming video subscription and on-demand revenue reached $6.2 billion, up nearly a quarter from $5 billion in 2015.

That $6.2 billion has even passed the traditional DVD business. According to the Digital Entertainment Group's annual report, U.S. consumers spent $5.49 billion on DVDs and Blu-rays, down 9.5% year over year.

In practice, any internet platform with enough subscribers, whether Netflix or Amazon, can hold its own in this industry without having to read the studios' faces the way it once did.

Because they hold so many consumers, these platforms can already ask traditional film companies for concessions, and a shorter window is one of them. And once they start making films themselves, they can also go around the channels traditional film companies control — DVD, the television networks — and find their own place in the industry.

In 2015, Netflix paid $12 million for the low-budget film Beasts of No Nation. Its zero release window drew a boycott from the four big North American theater chains, and only some smaller chains agreed to show it, so its opening box office was poor. But once the film went up on Netflix at the same time, word spread: online views jumped, and the box office turned positive too. Because it had a theatrical run at all, it also became eligible for a number of film awards.

Early last year, Netflix bought worldwide distribution rights to Martin Scorsese's big-budget film The Irishman. The Atlantic commented that it was unusual for the rights to such an expensive, star-packed Scorsese film to end up with Netflix rather than a traditional distributor.

From Beasts of No Nation to The Irishman, all of it suggests that Netflix does not need traditional theaters — a subscriber base that large is what gives Netflix the confidence it can earn back the cost of these films on its own.

An article in Vanity Fair argued that just as consumers have gradually given up whole albums for single tracks (or moved to streaming services like Spotify), and given up hardcover books for cheaper e-books, they will eventually stop going to movie theaters — going out to a film has become an expensive, inconvenient option with very little choice.

Instead, films will come to them, and a shorter window is only part of it. Consumers will also pirate the films they want to see: in 2015, high-grossing films were illegally downloaded more than 500 million times in the U.S. Or consumers may stop watching films altogether — YouTube, Instagram and Facebook are all taking time that used to belong to theaters.

None of this is necessarily good for the film business, because there will always be films that win praise without winning audiences and still cost a lot to make — the Blade Runner films, for instance. And Amazon, which put money last year into Manchester by the Sea, a nominee for the Best Picture Oscar, says this year it wants to make films for the mass market. When it comes to entertaining and pleasing a crowd, the West Coast companies have always been eager, and good at it.

Heavy borrowing has funded Netflix's expansion these past few years — and it is also its biggest risk

At the end of 2017, Netflix had $2.8 billion in cash on hand. Its long-term debt alone stood at $6.6 billion, and its total debt topped $10 billion.

Netflix's subscription business made money last year, but operating profit was only $800 million. Had it not successfully issued $3 billion in high-yield bonds, Netflix could not have kept buying and making shows on this scale.

High debt comes with greater risk. S&P Global Ratings currently rates Netflix B+, or "junk." A credit rating directly determines what it costs a company to borrow.

But because Netflix's momentum is strong, the capital markets do not much mind the junk rating, and the interest they ask of it is far below what Hollywood's traditional giants pay. Disney's blended borrowing rate in 2017 reached 9.73%, a full three percentage points above Netflix's. On the same $3 billion borrowed for a year, Disney would pay $90 million more — enough to make a mid-budget film.

Netflix's view is that its high market value supports the value of its bonds, since bond yields usually take a hit only after a market value collapse. Lindsay Gibbons, a senior analyst at CreditSights, agrees: even if Netflix's fundamentals deteriorated, a high market value provides a large cushion.

The Wall Street Journal commented that the market is willing to take the risk of lending to Netflix not only for the high yield, but also because of a general belief that as U.S. stocks climb to record highs, Netflix's market value will rise with them, which in turn keeps lifting the bonds these companies issue.

But U.S. tech stocks have already run up a long way. Netflix's market value is up nearly 200% since 2016, and Americans have lately been pouring into the stock market at a record pace. According to Bank of America Merrill Lynch data, investors' allocation to equities has jumped to a two-year high, while the household savings rate has fallen to where it was before the 2008 financial crisis.

If the economy turns, both the bond and stock markets will feel it, and that would directly affect Netflix's ability to raise cash. And like every new technology company, Netflix pays its staff partly in stock options, which are just as exposed to shifts in what the market expects.

Some of that risk is already visible. After Disney announced it was ending its agreement with Netflix and launching two Netflix-like services, Netflix's bond prices fell sharply — the logic of market value propping up bond value is not unbreakable.

By comparison, Amazon, Netflix's main rival, also burns billions of dollars a year on programming, but its core e-commerce and cloud computing businesses make billions in profit a year, enough to absorb violent swings in the capital markets. And Apple, which nets billions of dollars a quarter from the iPhone alone, has announced it will bring more than $200 billion in overseas cash back to the United States.

With Netflix raising its expected content spending for 2018 (to $7.5–8 billion) and its marketing spending (to $2 billion), analysts expect free cash flow to end the year somewhere between negative $3 billion and negative $4 billion.

"When is this company going to generate positive operating cash flow?" asked Stephen Flynn, an analyst at Bloomberg Intelligence.

But in an American capital market where everything is going up, Netflix does not seem to have time to worry about that.

Graphics/Feng Xiuxia

Cover image/nikey.co.vu