The relentless burden for Netflix and Spotify

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The relentless burden for Netflix and Spotify

In 2011, Marc Andreessen famously said “software is eating the world”, at the time software was setting the precedent for how industries would port their businesses from the physical to the digital world – Amazon’s imminent rise had already springboarded off its digital stores, even the kindle books were software according to Andreessen. At a similar time, Netflix was four years into the launch of its streaming services. Known as the disruptor that eventually dismantled the blockbuster model and relegated it to nostalgic memory, Netflix brought the silver screen to our personal computers through software. Spotify did the same for music. What is so lucrative about software is its zero cost (or approaching zero-cost) model, once the software has been developed its scalability doesn’t commensurately scale costs – it leaves margin woes to physical manufacturing and distribution businesses. Even SAAS (non-static software) approaches the zero cost model, its main hurdle being ongoing maintenance and upkeep. What is unique about Netflix or Spotify though, is the nature of manufacturing – a quality experience of music and movies came with an appropriately significant price tag associated with the costs of direction, sets, cinematography and studio production. Sitting somewhere between the Blockbuster era and the pervasive software model of today, how long can Netflix or Spotify remain dominant in face of the need to meet quality expectations and manage margins in increasingly competitive industries?

The aim was to replicate the cost model of software, an upfront cost of software development that could be distributed digitally without an upper limit on its reach. Online platformisation allowed Netflix and Spotify to distribute entertainment on a scale it never had been before, the only limit being the platform’s ability to acquire and retain users. However, unlike software, the reality for high production cost streaming services is that while distribution was solved by the digital age, production and licensing costs could not be shed. 

The persistence of legacy costs in digitalising high production content 

While Amazon also required authors to write the books it was digitally distributing, it’s important to note that Amazon didn’t foray into the original production of books – in fact, it made it easier for authors to self publish. While the costs of book production are vastly different (and significantly less) compared to movies and music, Amazon optimised its move toward ‘ zero costs’ through an approach to production that prioritised scale and margins. This is not to mention that Amazon’s software business has now laterally expanded far beyond the sale of e-books to more zero-cost friendly verticals like AWS. While music on Spotify is similar to Amazon’s e-books in some ways its licensing model pays royalties for all streams (free or paid), whereas Amazon pays royalties upon sale – the reason royalties plague the Spotify model but not necessarily the Amazon Kindle model. Netflix, on the other hand, has the added margin squeeze of needing to compete on original content to acquire the users that can profitably scale its distribution capacity. 

From this, we can categorise the ongoing costs of entertainment-software distribution companies into:

  • Creative costs
  • Licensing and ownership costs

Popular movies, shows and songs are not predictable models. Even if they were, they come with huge marketing costs per production. These costs are not scalable, they are specific and unique to each production. Creative costs then flow into the price of licensing and ownership. 

Netflix
Digital offering – Connecting production houses (licences) to subscribers 
Zero cost – Distribution
Ongoing cost – licencing – most of their revenue goes to licencing 

Spotify
Digital offering – Connecting artists to subscribers
Zero cost – distribution
Ongoing cost – royalties – most of their revenue goes to artists

Netflix and Spotify can combat the burden of licenses and royalties as ongoing costs by pursuing two avenues:

  1. Creation of original content – remove ongoing costs by replacing it with upfront costs
  2. Introduction of a user-generated content model – removes the burden of production and creative costs from the platform’s supply chain 

The Netflix Model

Of course we know, Netflix has consolidated its streaming dominance through its original content already. Netflix began as a digital service and not a production house, meaning they initially had to lean into the licensed content already available on the market. This dependency created further strains on the cost of acquiring content libraries for Netflix when popular shows garnered the additional bargaining power to negotiate better rates for ongoing renewals. This would mean that even as the number of subscriptions increased, the cost per user would still remain very high. 

In its current state, Netflix is starting to lean more heavily into original content creation for two reasons. The first, as mentioned, is to combat ongoing licencing costs that eat into their margins per user acquired. The second is the knowledge that Netflix was not originally a production house and ultimately faces an existential threat from competitor production houses like Disney and CBS who have decades of content to leverage. These competitors can easily replicate the model that Netflix has made popular and the success of Disney Plus is a testament to this. While original production does mitigate ongoing costs, there is a lifetime on each spurt of investment. As audiences switch from one show to the next (a binge culture Netflix popularised), Netflix will need to continue producing at quite a rapid pace – at what point does the cycle of upfront investment become a recurring cost in and of itself? Of course, the scalability of distribution available to Netflix through its digital platform makes this much more profitable than traditional production and distribution. 

The Spotify Model  

Whilst this route seems somewhat straightforward for Netflix, the Spotify model is a bit more complicated as it attempts to achieve the zero cost digital model. It isn’t as simple as saying Spotify should become a music production company.  

The reason Spotify has a more complicated proposition is because of the nature of music and how users consume music. The sheer volume of music available to consumers cannot be supplemented by a single production house. Where music is not scalably producible in-house, Spotify and other music streaming services are likely to always carry the cost of royalties. Where Spotify is unlikely to ever de-couple its music business from the costs of royalties, the platform’s margin-costs have an insurmountable barrier in moving towards a zero-cost digital model. 

While the introduction of podcasting as an avenue for expanding the Spotify proposition might on the surface appear as them moving their platform towards a zero cost digital model. However, it is actually more akin to creating a separate platform for the purpose of augmenting the revenue stream of their music service. It does not do away with the high-cost licensing burden of their music service.

However, Spotify’s podcasting business does represent a closer approximation of the zero cost digital model than its music service. Spotify is licensing popular content that can create the initial traction for their podcast platform. The ideal scenario for Spotify is to eventually introduce the user-generated content model for podcasting, and gradually do away or reduce drastically the licensed content. This would look like a ‘Youtube for podcasts’ platform where the margin cost associated with production and licencing is shifted to creators and consumers. At this stage, at least their podcasting service will evolve to become a fully digital solution where discovery and distribution is the core proposition. 

The reality of digitalising high-cost production content for both Netflix and Spotify will always present a persistent battle to reduce or do away with margin costs. This then relegates these business models to compete on the singular prospect of margins where growing competition will start to eat into their revenue streams. In a decade, Netflix and Spotify might represent a niche of Tv and Music streaming more than the dominant platforms they are today. The persistent dominance of a platform like Netflix would hinge on its original content – but this would be an inherent shift away from the software model to a more traditional production house – the traits of the traditional entertainment industry continuing to shape its modern descendants. 

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