Member Mailing: Netflix's Failing Disney Ambitions Invite The Keeper Test for Co-CEOs Hastings & Sarandos
Stratechery’s Ben Thompson had a good interview last week with Michael Nathanson, media analyst and co-founder of MoffettNathanson.
I think this interview is particularly valuable for their discussion around how growth will become more expensive for both Disney+ and Netflix. Specifically, the premise is that content investment is a fixed cost that is assumed to “pay off in customer acquisition over time” in a subscription model, but being forced to localize content that “just doesn’t have the same economies of scale as what people thought”.
I also think this discussion misses an important point about marginal revenues versus marginal expenses: Disney’s advantage over Netflix is that Disney can create marginal value for streaming subscribers from investing in and marketing original IP, and then monetize them in multiple ways within Disney's ecosystem. But, Netflix has yet to prove it can create marginal value from investing in and marketing its original IP beyond subscription revenues. [1]
Netflix's failures with owned-and-original IP like last summer’s "Jupiter’s Legacy" - the first in its attempt to build out the Millarworld IP it acquired in 2017 - have been within an iterative process towards management’s aspirations to build a Disney-like ecosystem with owned and original content. But, Netflix’s operational failures in animation - reported recently in The Wrap - are also failures to develop original IP. Given that ~60% of all Netflix subscribers watch kids and family content every month, those failures seem more significant. [2]
Together, both problems suggest that co-CEOs Reed Hastings and Ted Sarandos may no longer be the best leaders for a post-pandemic Netflix, especially one that needs to extract more marginal value and marginal revenues from its investment in original IP. The two have proven that, despite their extraordinary success to date, they cannot deliver against a business objective that is increasingly important as growth slows and becomes more expensive.
Marginal acquisition costs for Disney+ & Netflix
As Netflix invests in its owned and original content, Thompson’s question is to what extent is content spend actually marketing spend? How much does it actually draw new customers?
Thompson hypothesizes is that Netflix and/or Disney will “hit this wall where you can no longer acquire the marginal customer in [international] countries because they’re not interested and they can’t afford it”. He also thinks:
"Companies build lifetime value models and derive their customer acquisition costs numbers from those initial customers and then they say, “These are our unit costs”, and those unit costs don’t actually apply when you get to the marginal customer because you end up spending way more to acquire them than you thought you would have."
Nathanson agrees with this take and reframes the problem for Disney, specifically:
That’s my question to Disney, which is, and I think you wrote this — your first 100 million subs, look at the efficiency of how you built Disney+, it was a hot knife through butter. But now to get the next 100 million subs, what are you going to do? You’re going to add sports, do entertainment, more localized content. My question to Disney is, is it better just to play the super-fan strategy where you know your fans are going to be paying a high ARPU and always be there, or do you want to, like Netflix, go broader?
“Go broader” refers to Disney aiming to expand Disney+ into over 200 countries and territories - it has only reached 30% of that total, to date, reaching 64 countries and expanding to 42 more countries and 11 new territories today (June 8th).
Nathanson’s question is whether Disney+ would be better off monetizing its super-fans better with existing library in the short term - they’re effectively zero churn - than in trying to hit a promised target of over 260MM subscribers with local content. Because its target markets may not be mature enough for the type of growth Disney+ needs or that Disney management has promised (230MM to 260MM by September 2024).
Local content generally does not scale internationally, so any marginal growth towards that objective will be more expensive than in the past.
But, streaming has more value to Disney than Netflix
I concluded in a recent essay that “for the foreseeable future, a Disney+ subscriber can reap more value from their subscription than from a Netflix subscription simply because Disney has more assets to offer them.” That conclusion was based on two recent bundle offerings:
Disney+ subscribers can save up to 25% on their visits to Disney World theme parks most nights between July 8 through September 30, 2022; and,
A new National Geographic Premium with Disney+ subscription bundle
Disney is able to segment its target audiences to maximize revenue across business divisions. That is a significant advantage within Disney's streaming strategy that Netflix simply does not have. Meaning, the moment a streaming subscriber has signed up, Disney can generate marginal value for that consumer, and therefore marginal revenues from that consumer. But Netflix can do neither (see footnote [3] below re Netflix.shop).
Disney CEO Bob Chapek discussed this on the last earnings call: “In recognition of Disney+'s unique ability to attract viewers from a range of demographic groups, we are selectively enhancing Disney+ with general entertainment titles designed to drive sign-ups among specific audiences and deepen engagement among those cohorts.”
He then concluded with the example of “Toy Story”. It is worth including the entire quote because it encapsulates just how multi-faceted and powerful the Disney ecosystem is for these types of bundles:
What sets Disney apart is our ability to reach people with our uniquely engaging content across an array of touch points to make our portfolio of businesses and brands a bigger part of their lives. This enables us to not only create new franchises like Encanto, but to also build on existing IP across our lines of business. One example of this is our Toy Story franchise, which was created almost three decades ago with the release of the first film in 1995 and which is now brought to life across distribution platforms, geographies, businesses and time. In our parks, we've built a portfolio of four immersive Toy Story lands with more than 20 attractions and live character interactions available around the world, as well as two themed hotels.
The franchise is the cornerstone of Disney+ with all four feature-length films, as well as the original short series, Forky Asks a Question, exclusively available on the service. And nearly 30 years after the film debuted, Toy Story is still a key consumer products franchise, generating over $1 billion in annual retail sales. And in just a few weeks, Pixar's Lightyear will tell the origin story of everyone's favorite space ranger when it hits theaters on June 17. Of course, Toy Story is just one of our many franchises, but it illustrates our unparalleled ability to bring stories to life in more ways for more people in more places.
There is also a data component to this strategy, as Chapek outlined last year to the JP Morgan Global Technology, Media and Communications Conference
…for the very first time, we've got the opportunity to take our original direct-to-consumer business, which is our park business, and use it for our newest direct-to-consumer business. And we've got [a] tremendous amount of information on our consumers from our parks business and what would happen if we married that and actually mine that data to help people subscribe to Disney+ knowing what we know.
I think that Thompson’s and Nathanson’s apples-to-apples comparison of Netflix and Disney+ investments in original content falls apart when considered in the context of ecosystems. As I have argued previously, through the lens of a Customer Data Platform (CDP), Disney is laying out for investors the “early days” of a broader business strategy where streaming consumers may be monetized in multiple ways across the Disney ecosystem. But Netflix has been and continues to be unable to replicate that model.
So content investment as Customer Acquisition Cost (CAC) to acquire new international subscribers for growth has a very different calculus for Lifetime Value (LTV) for Disney than it would for Netflix. And since 2017, Netflix has been openly telling investors that it actively has been seeking to change that calculus.
Netflix's shortcomings with Millarworld IP
Thompson and Nathanson are speaking more broadly about original content investment - local productions that Netflix and Disney either own or co-produce. But, it is important to remember that Netflix management had been both openly and coyly promising investors that building a Disney-like ecosystem was their long-term objective:
In September, Netflix co-CEO Reed Hastings told the New York Times that two of the best authors in the entertainment industry were Neal Gabler, who wrote the definitive biography of Walt Disney, and Bob Iger, who literally ran Disney. In February, Hastings told investors that Netflix’s long-term aim is to beat Disney at animation: “We’re very fired up about catching them in family animation, maybe eventually passing them, we’ll see. A long way to go just to catch them.”
Acquisitions of IP like Millarworld in 2017, the StoryBots franchise in 2019, and later the Dahl library in September 2021, were cornerstones for this bigger vision.
The launch and failure of “Jupiter’s Legacy” one year ago - it was almost immediately not renewed - was the first initiative against this objective. I was interviewed then by Observer and now-The Wrap reporter Brandon Katz: “I’m obviously painting broad brushstrokes here, but the point is, as much as Netflix talks about Disney and animation as business objectives, it is harder to discern where the wins have been for them”.
Back then, the failure of “Jupiter’s Legacy” seemed like a “black eye” for Netflix, as researcher The Netflix Film Project argued then, “something on par with Universal's Monsters Universe flopping hard out of the gate”. It was Netflix’s first failure on this path of developing IP from acquired properties.
The positive reception to Millarworld’s anime follow-up “Super Crooks” - released in November 2021 - suggests Netflix management found its feet again with Millarworld IP. But, the viewing data for “Super Crooks” has not been aggressively marketed by Netflix PR, it does not show up in Netflix’s published Top 10s, and unlike “Jupiter’s Legacy”, it has not shown up in Nielsen.
Why Netflix's failures in animation matter
So, I would argue if there is a significant failure to develop IP here, it is more so the failures in the animation division. ~60% of all Netflix subscribers watch kids and family content every month, and management’s objective is to be a competitor to, if not a next-generation, Disney. But, we recently learned from The Wrap that recent executive firings brought “perhaps an inevitable end to a deeply chaotic period for Netflix Animation, particularly its Kids & Family division, which saw a boom of talent and creativity give way to corporate pressure, mixed messages and accusations of ‘staged data.’”
Netflix Animation also recently saw cutbacks of an additional 70 workers, but perhaps most notable was the report that “several animation projects have been sent back to development, including the highly anticipated 'Matilda' animated series, based on the Roald Dahl novel.”
“Matilda” came with Netflix's September acquisition of the Dahl catalog, so the move suggests that Netflix does not have as much confidence in the development processes or the business model within Netflix Animation as it once did. At a deeper level, the implication is that the division responsible for the majority of Netflix's monthly consumption cannot deliver a return on investment on original IP or against the objective of competing with, if not surpassing, Disney (and, this parallels Netflix's failures with Millarworld IP, to date).
Netflix's top five most popular franchises - PAW Patrol, Gabby's Dollhouse, and CoCoMelon, Peppa Pig, and Pokémon Journeys - are all owned by third parties.
The Keeper Test
These significant failures bring to mind Netflix’s Keeper Test: if a team member was leaving for a similar role at another company, would the manager try to keep them?
I think the failure of “Jupiter’s Legacy”, alone, does not merit applying the Keeper Test to co-CEOs Hastings and Sarandos. So, if we are going to apply the Keeper Test, it’s worth focusing on this passage about Netflix's culture:
Succeeding on a dream team is about being effective, not about working hard. Sustained “B” performance, despite an “A” for effort, gets a severance package with respect. Sustained “A” performance, even with a more modest level of effort, gets rewarded. Of course, to be great, most of us have to put in considerable effort. But we don’t measure someone’s contribution by the hours they work.
I think it is objectively clear that Netflix’s failures in animation are reflective of deeper, structural and operational challenges under current management to develop owned and original Disney-like IP. Those challenges highlight areas where Co-CEOs Hastings and Sarandos have been ineffectual, and despite their grandiose sales pitches to investors and employees.
These are fundamental operational weaknesses in a division they told investors had fundamental operational strengths. So should they stay?
By their own standards, the answer is obviously no. [3]
If the evolution into a next-generation Disney is a necessary objective to accomplish in order to create marginal value for consumers and marginal revenues for shareholders, then Hastings and Sarandos have proven to be the wrong management team for accomplishing that objective.
My sense is one or both will soon magnanimously step down - or more likely step up into co-Executive chairman roles - in favor of a CEO who better understands IP development and has a background in animation. If I were to speculate as to who would replace them, my guess is the ideal candidate(s) will be from Pixar, which is also a software business that has a proven track record in developing owned and original IP within the Disney ecosystem.
Conclusion
Over the weekend MrBeast released “I Built Willy Wonka's Chocolate Factory!”, his second Netflix IP-themed production since last November, when he posted a real-life version of Netflix’s “Squid Game.” He produced it on a $3.5 million budget but released it for free.
There is a key, if not enormous, difference between those two videos: in the Squid Game video, he built a success off of IP Netflix previously distributed. But, as above, Netflix has yet to release any Dahl IP and already has sent back a major title, “Matilda”, to development.
Also, unlike Netflix, MrBeast has a model for creating marginal value: in the video, he is marketing MrBeast Feastables Chocolate Bars (which he also handed out at Upfronts). At 50MM views, assuming he converts 1% of that audience to a sale of one ten-pack of chocolate at $29.99 per pack, he will have grossed at least $15MM in chocolate sales in three days, and that will be on top of what he grosses in YouTube revenues ($54MM in 2021, around half of which comes from ads).
MrBeast offers a brutal funhouse mirror on Netflix’s failures to achieve its promised objectives of Disney-like marginal value from owned IP. Because MrBeast has proven that these objectives can indeed be accomplished with Netflix-owned IP, and faster, cheaper and perhaps even better than Netflix could under current management.
In other words, MrBeast is now monetizing Netflix IP better than Netflix can, at a similar scale, and while Netflix management struggles with a similar strategy. I think that is an important perspective that a narrower focus on original content as a marketing expense misses.
Footnotes
[1] This is reflected in the PARQOR Hypothesis, which argues that the media businesses most likely to succeed in streaming and beyond must meet five attributes, and highlights any missing pieces they (arguably) may need to solve to succeed.
[2] Netflix is building out additional sources of revenue for its “Bridgerton” and “Squid Game” properties, but neither are Disney-esque objectives.
[3] One counterargument they could make is that Netflix does have Netflix.shop, an online store that features products inspired by shows on its streaming platform. It launched one year ago. But, at best, marginal revenues generated from that store are maybe $0.01 or $0.02 in Average Revenue Per Member (ARPM). Maybe.