Member Mailing: Rethinking the "Distribution Moats" of Netflix & Spotify In 2024
Good afternoon!
The Medium delivers in-depth analyses of the media marketplace’s transformation as creators, tech companies and 10 million emerging advertisers revolutionize the business models for “premium content”.
Each fiscal quarter, The Medium identifies three or four new trends that have momentum and seem poised to play out at a larger scale in 2023. These key trends pinpoint dynamic and constantly evolving developments in the media marketplace that are emerging from incremental shifts or fundamental changes. The bi-weekly mailings analyze these trends as developments emerge in real-time.
Read the three key trends The Medium will be focused on in Q4 2023. This essay covers "the less-discussed lens on how the demand for “premium content” is being redefined by creators, tech companies and 10 million emerging advertisers" and "In the shift from wholesale to retail models, there are many business models that delight consumers but no single, dominant one."
Author’s Note: My monthly Medium Shift opinion column —”Media Executives Covet Games, but Are Ill-Suited to Run Them”— went live yesterday. I wrote about how in 2023, gaming and Hollywood increasingly overlapped in the zeitgeist. Gen Alpha and Gen Z are increasingly spending as much time gaming as they are streaming. And no legacy media company is positioned to take advantage of serving those consumers across both marketplaces.
Spotify CEO Daniel Ek announced layoffs of 17% of its staff earlier this week (1,500 employees). The explanation was it had taken advantage of “lower-cost capital” in 2020 and 2021, to invest “significantly in team expansion, content enhancement, marketing, and new verticals”. The investments “ generally worked, contributing to Spotify’s increased output and the platform’s robust growth this past year”, but Spotify now finds itself in “a different environment”. Its cost structure “is still too big”, and the company is “more productive but less efficient.”
Spotify benefits from what I described in “Why So Many Streaming Services Are Struggling” as “The Distribution Moat”: The technological expertise behind the algorithms for personalized recommendations, the dynamic user interfaces and operational back-ends for content distribution over the internet. This moat is an advantage in video streaming, and an advantage in audio streaming, too. Spotify has captured over 30% of the streaming market share with 574 million users, including 226 million subscribers. But, unlike Netflix and Hulu with “Distribution Moats”, it is not profitable.
Notably, Netflix has made it out of the zero-interest-rate-policy (ZIRP) era with a profitable model, and Spotify has not. Spotify now finds itself in similar territory to legacy media companies with cost-cutting efforts and layoffs, cutting original content funding for critically acclaimed podcasts. As media distribution models sort themselves out in a post-ZIRP, higher interest rate world, the question posed by Spotify’s challenges and Netflix’s pivot to gaming is whether a “Distribution Moat” will still be an advantage heading into 2024 and beyond.
Key Takeaway
In 2023, the "'Distribution Moats" of Spotify and Netflix saw the economics of the supply of content shift towards commoditization and the demand for content is increasingly shaped by commoditization, too. Those trends both undermine and reinforce those moats.
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Commoditized Content Economics
Back in January, Netflix was facing lingering questions about its “Distribution Moat” after reporting its first decline in subscribers back in April 2022. An essay in the Financial Times then argued that Netflix’s “wobble” should “make clear to investors that content is more valuable than the platform.” Netflix had taken advantage of ZIRP marketplace dynamics to raise billions in debt to both buy and finance shows and movies. The lesson from Spotify and the music industry is that “Sony, Warner and Universal Music were always more valuable than Spotify.” Therefore, video streaming licensors like Sony were better off being "arms dealers".
Almost one year later, Netflix’s renewed growth—if not victory in streaming—means that Hollywood studios increasingly will need to turn towards licensing to Netflix, effectively commoditizing their libraries into food for Netflix’s algorithms while killing their proprietary services. Netflix seems inevitably headed towards becoming a Spotify for Hollywood video content with better economics for Netflix, but in which the studios do not have ownership stakes (unlike Spotify). The "arms dealer" models increasingly being pursued by Warner Bros. Discovery, Disney and NBCUniversal are emerging at the expense of their own streaming services and their failure to build ownership stakes in Netflix the same way record labels did with Spotify.
Spotify faces challenges of feeding its algorithms with library content, as I wrote in May’s “The Medium Is A Firehose”. As of last October, 100,000 tracks are being “added to music platforms every day” through artist and creator uploads, according to Universal Music Group CEO and Chairman, Sir Lucian Grainge. He added “this vast volume of music, plus additional “associated content” on social platforms, is making it increasingly difficult for artists to break through to a substantial audience online.” Licensing for labels is starting to see decreasing returns as Spotify expands its supply of content.
Questions For The Long Term
The question both companies now face is whether feeding a content library into a sophisticated distribution platform is both a defensible moat and viable business model in the long term. The obvious answer is, yes, both marketplaces are effectively now either invested or reliant upon these Distribution Moats holding up. Therefore, their businesses should be viable.
But, both businesses have evolved well past the original visions and business models of their founders. Spotify has expanded into podcasts, which were never part of Daniel Ek’s original vision in 2006, and became a necessity for an alternative source of revenue when paying out 70% of streaming revenue to labels and artists became too expensive. Podcasts do not have the same economics because Spotify does not pay them directly (also the key reason why it is expanding the sources of content to its platform, which it can monetize with advertising and subscription revenues).
As for Netflix, I wrote in January’s “Reed Hastings Steps Down (and Up)” that its moves into gaming and ad-supported streaming both fall outside of Executive Chairman and co-founder Reed Hastings’ skillset and advertising in particular “notoriously falls well outside of his vision.” Netflix is now attempting to expand into games to protect those moats, reduce churn and better monetize their audience bases. But, it is also in new territory, well past its vision of streaming replacing cord-cutting, and it is inventing the roadmap as it proceeds.
So, these evolutions for Netflix and Spotify are succeeding. But, the question for Spotify in 2024 is whether they will ever lead to profits. The question for Netflix in 2024 is whether games will be as impactful for user growth and churn prevention as their increasingly aggressive roadmap implies. CNBC reported in October that games have been downloaded 23.3 million times and averaged 1.7 million daily users, less than 1% of total subscribers and 2.5% of U.S. subscribers. The impact seems to be marginal but positive.
In other words, for how much longer are these “Distribution Moats” actually profitable and therefore defensible the more that their owners iterate away from the foundations of those moats? Because both companies seem vulnerable.
“A digital everything product”
On this point, it is worth revisiting an argument made by former WarnerMedia CEO Jason Kilar that most media companies not named Netflix are not positioned to generate attractive cash flow from streaming. Their better bet would be “contributing a branded, continuously updated programming lineup” to “someone else’s scaled, heavily used streaming service”. In return, they would receive a share of the ongoing revenues from a scaled streaming service that reads an awful lot like Hulu as a version of the Spotify model for TV and movies.
The implicit argument was that Netflix is vulnerable to competition that can figure out a “Distribution Moat” that also generates cash flow. Kilar was nodding to Hulu as a potential alternative “Distribution Moat”, assuming legacy media companies would bet on this new Hulu model and then (mostly) stop doing business with Netflix
On the other hand, Spotify dominates its marketplace, and no actual or hypothetical competition is positioned to replace it. More importantly, the record labels are not incentivized to kill something they own. So, the question is how Spotify achieves profitability while it pays out 70% of its revenues to third parties, annually, and while its content mix is changing due to the scale of creator uploads. The fundamental use case is not changing but the supply of content is evolving enough that the economics will inevitably evolve.
The question for both platforms in 2024 is whether they can reach profitability or continue to be profitable as the economics of the supply of content shift towards commoditization? What happens as the demand for content is increasingly shaped by commoditization, too? The answer to both questions is not "The Distribution Moat", alone.