Hey friends -

Netflix earnings came out this past Tuesday. Analysts had predicted continued subscriber growth, but the company actually lost subscribers in the period. That's a problem for a company that generates its revenue from subscriptions. For the first time, CEO Reed Hastings opened the door to Netflix ads:

Related to that, Greg has done great work on the price spread. And one way to increase the price spread is advertising on low-end plans and to have lower prices with advertising. And those who follow Netflix know that I've been against the complexity of advertising and a big fan of the simplicity of subscription.

But as much I'm a fan of that, I'm a bigger fan of consumer choice and allowing consumers who would like to have a lower price and our advertising tolerant get what they want makes a lot of sense. So that's something we're looking at now. We're trying to figure out over the next year or 2. But think of us as quite open to offering even lower prices with advertising as a consumer choice. [...]

We're probably not that advanced, but now, I think it's pretty clear that it's working for Hulu. Disney is doing it. HBO did it. I don't think we have a lot of doubt that it works, that all those companies have figured it out.

Thanks to Liberty for the quotes and highlights.

I’ve read countless articles and headlines that discuss the future of Netflix and Netflix ads. All of them missed the point. Subscriptions and advertising are incompatible, they do not mix.

You heard it here first - it's the beginning of the end for Netflix.

In this week's letter:

• Netflix ads and a tragedy of the commons: the incompatibility of subscriptions and advertising, a brief history of how badly the combination turns out, and Netflix's demise
• The True Price of groceries including environmental costs, two required readings, and more cocktail talk
• A drink to think it over

Total read time: 9 minutes, 36 seconds.

Netflix Ads and a Tragedy of the Commons

Warren Buffett was famously a long-time newspaper enthusiast. In 2012 alone, Berkshire Hathaway acquired 28 daily newspapers for $344 million.

He's no longer as enthusiastic. To use his turn of phrase, the newspaper industry is "toast."

Newspapers used to be free to subscribers in the pre-internet era. Each local paper was a monopoly that monetized eyeballs - if you were a local business that wanted to get the word out, ads in the newspaper were your megaphone. It was a business model that aligned readers' interests and the newspaper's economics. In Buffett's words:

Additionally, the ads themselves delivered information of vital interest to hordes of readers, in effect providing even more “news.” Editors would cringe at the thought, but for many readers learning what jobs or apartments were available, what supermarkets were carrying which weekend specials, or what movies were showing where and when was far more important than the views expressed on the editorial page.

But it was an uneasy alliance. Advertising can crowd out actual news, as Buffett acknowledged in 1983 (emphasis mine):

The [Buffalo] News lives up to its name - it delivers a very unusual amount of news. During 1983, our “news hole” (editorial material - not ads) amounted to 50% of the newspaper’s content (excluding preprinted inserts). Among papers that dominate their markets and that are of comparable or larger size, we know of only one whose news hole percentage exceeds that of the News. Comprehensive figures are not available, but a sampling indicates an average percentage in the high 30s. In other words, page for page, our mix gives readers over 25% more news than the typical paper. This news-rich mixture is by intent. Some publishers, pushing for higher profit margins, have cut their news holes during the past decade. We have maintained ours and will continue to do so. Properly written and edited, a full serving of news makes our paper more valuable to the reader and contributes to our unusual penetration ratio.

The history of local papers is all but played out at this point - eyeballs moved to the internet, advertising revenues for local papers plummeted, and most closed their doors. A few success stories are buried within the industry demise, all of which switched to subscription models. Buffett from 2012:

The Wall Street Journal went to a pay model early. But the main exemplar for local newspapers is the Arkansas Democrat-Gazette, published by Walter Hussman, Jr. Walter also adopted a pay format early, and over the past decade his paper has retained its circulation far better than any other large paper in the country. Despite Walter’s powerful example, it’s only been in the last year or so that other papers, including Berkshire’s, have explored pay arrangements. Whatever works best – and the answer is not yet clear – will be copied widely.

We know how this story ends because we're living it. Subscriptions helped newspaper economics but weren't sufficient. Papers have instead pursued a combined subscription and advertising model. While the business model has temporarily helped the economics of some papers, news quality has been the victim. Buffett unwittingly predicted the outcome in two passages in 1990 and 2006:

Regardless of earnings pressures, we will maintain at least a 50% news hole. Cutting product quality is not a proper response to adversity.

Advertisers preferred the paper with the most circulation, and readers tended to want the paper with the most ads and news pages. This circularity led to a law of the newspaper jungle: Survival of the Fattest.

What he inadvertently articulated was the fundamental incompatibility of subscriptions and advertising. There's only one outcome - a tragedy of the commons.

Netflix Ads & Subscription: As Compatible as Oil and Water

In a subscription-based business model, the relationship between producer and consumer is straightforward. The producer sells the product to the consumer. The consumer uses the product and pays the producer. That's it.

Advertising is a bit more complicated because we've introduced a third party, the advertiser. In theory, the producer delivers a product to the consumer, the advertiser delivers ads to the consumer, and the advertiser pays the producer.

But that's not an accurate representation. Each of the relationships is a two-way street, a give-to-get. The producer sells a free product to the consumer. The consumer uses the product and pays the producer in data and time. The producer bundles that data and time into a paid product which they sell to the advertiser. The advertiser pays the producer. The advertiser then uses the paid product to deliver ads to the consumer, who pays the advertiser in clicks and eventual purchases.

Both of these business models are perfectly successful by themselves. The problem comes when you try to combine them.

The producer is double-dipping! The only way the producer can offset the double-dip is to modify the value of the product delivered to the consumer. Product value is inherently difficult to measure, but it can be done successfully in a subscription model. Netflix already does it today - $10 a month for Basic, $15.50 for Standard, and $20 for Premium. Consumers self-select if they think the features available with Premium are twice as valuable as basic.

It all falls apart when you add advertising.

Let's create a new Netflix ads tier that's $5 per month. You get the same features as Basic but you're shown a 30-second ad every 15 minutes. Consumers can self-select which option they think is best. All fine and good.

But then Netflix gets a phone call from its largest advertising customer. They just launched an award-winning campaign, but each ad runs for 35 seconds. Netflix wants to keep their customer happy - and really what's another 5 seconds to the consumer anyways? At a $5 price point, consumer demand is inelastic with regards to another 0.6% degradation in product quality.1 It'd be silly to reduce the Netflix ads tier price by $0.03 to reflect the revised product quality, so the ad runs and the product quality slips ever so slightly. Customers are left paying the same price for an inferior product.

Once cutting product quality starts, there's no logical stopping point. It's why Buffett held firm at an arbitrary 50% news hole - it matters less where that limit is than the fact that it exists and holds firm. Otherwise, the business will find itself in the same position as the anecdotal frog in a pot of water - the temperature goes up slowly until it's boiled.

The challenge with digital is that "holding firm" is nigh impossible. Hold firm at a 30-second limit for ads and someone will sell ads on the login screen. Limit ads to just the shows and someone will sell product-placement ads in the shows themselves. Restrict ads to just non-US and someone will sell ads in Puerto Rico. A company has little chance of preventing inevitable product quality declines against a well-paid advertising sales team that has a massive incentive to see the quality slip ever so slightly for just this one deal.

It leads to a tragedy of the commons.

Tragedy of the commons

The canonical tragedy of the commons is grazing animals in the town square. The square can only support a limited number of grazers, but there's no check on how many animals each farmer grazes. In an attempt to make more money, each farmer adds extra animals. That might be fine for one farmer, but collectively the total grazing exceeds what the town square can bear. The overgrazed town square fails.

A key aspect of a tragedy of the commons is that every actor agrees that they don't want the town square to be overgrazed, but it's all the other farmers who should reduce their grazing. But that's not a good decision for any farmer - the moment they graze less, another farmer will take the opportunity to graze more.

The advertisers and their proxies, the Netflix ads sales team, face exactly this crisis. All of the advertisers want the Netflix product quality to be maintained, but they also want to make more money. They want everyone else to "hold the line" while they incrementally move it.

There's no obvious check on the incremental product degradation. Salespeople have to hit quotas and executives have to report revenue growth to investors. When new subscriber growth stalls, the only place to turn is to sell more ads at the expense of product quality. Soon that builds on its own momentum and the product is "toast."

We're already seeing it with many tech companies trying to squeeze more revenue out of existing products. Google has infamously incrementally updated its ad design to look more and more like search results. Yes, clicks go up, but the most recent update was so egregious that users (finally) complained and forced Google to backtrack. That's not a good look when you're being investigated for abusive, monopolistic tactics.

Amazon is on a similar path to ruining its user experience. I recently purchased a new Logitech C920s webcam. It's the sixth result. Above it are five imposters and one that looks right until you realize that it's a more expensive two-product bundle. All are ads. The company's still "customer obsessed," but the consumer is no longer the customer. It's the advertiser.

Newspapers are already in the end game. Most of the companies are out of business. The content quality at the handful that are left is generally poor. Actual news is replaced with clickbait that helps sell ads. Readers continue to leave in droves so the newspapers sell more ads to make up for the losses. Rinse, wash, and repeat until the paper goes bust.

Netflix shares the same fate.

Netflix's Untimely Demise

Netflix ads sets the company on a path to its demise.

The company doesn't have customers locked in the way your internet servicer provider does. It doesn't have the convenience advantage the way Google is the default search engine for almost every browser. Netflix doesn't even have the only available streaming service the way Amazon has the only "everything" store. Instead, it's in a now competitive media streaming industry with highly discerning consumers. Testing whether they're tolerant of quality degradation is a poor strategy for success.

Most of Netflix's 200+ million customers are outside the US where the volume and quality of Netflix may still be meaningfully differentiated against local competitors. Certainly few local companies could compete with the $17 billion Netflix spent on content in 2021. But any moat from the company's penetration into 190 countries won't last. Disney, Amazon, and Apple all have deeper pocketbooks and adept distribution strategies. Netflix should expect consumers in every market to rapidly become as discerning as those in the US.

Netflix will no longer be the high-flying FAANG member. It'll come crashing back down to Earth, just another company wringing out the last dredges of profit from a rotting product delivered to an ever-declining user base. The chapter will close as Netflix is acquired by a private equity firm for a fraction of what it cost to build the content in the first place.

Or, Netflix could choose a different outcome.

It is, after all, in the business of delivering leisure-time entertainment to consumers across the globe. Since Reed Hastings co-founded the company in 1997, a whole world of competing digital entertainment options has sprung up. Video games in North America are now bigger than sports and movies combined. Podcast listener growth continues at high rates. Even the e-book market size continues to grow. All of them compete with Netflix for our attention.

All these digital entertainment industries - and many more besides - lend themselves to direct producer-consumer relationships, one where the producer sells a product to a consumer, and that consumer uses the product and pays the producer. A subscription like what Netflix sells today is but one way to monetize that commercial exchange.

The opportunity is theirs for the taking. Netflix's history is one of massive change, from DVD mailer to streamer. Expanding the product catalog beyond movies and TV to other attention products could be yet another chapter in the company's success.

Cocktail Talk

• The original promise of the internet was decentralized. The free flow of information around the world. Reality is becoming increasingly centralized with entire sub-networks like China effectively cutoff. The internet, as I previously wrote, is not some abstract concept but a physical connection of tubes and data centers around the world. The ongoing efforts by China and recent efforts by Russia threaten to break a worldwide network into separately managed enclaves. Even well-intentioned policy, like preventing Russia Today from publishing in Europe, furthers this fracturing and eats away at the very foundation on which the internet was built. Thanks to Refind for sharing. (MIT Technology Review)
• How much do things really cost? True Price, a Dutch nonprofit, is attempting the near-impossible - quantify the costs of externalities like carbon footprint and soil erosion. A small handful of stores have started displaying the "true price" next to the actual price and letting the customer decide. It's a bold strategy, fraught with challenges, but one that might just help consumers make better choices. (Farnam Street)
• Jamie Dimon, CEO and Chairman of JP Morgan, publishes an annual Letter to the Shareholders. His most recent came out a few weeks ago. It's on a shortlist of annual required reading even if you're not interested in the bank. By virtue of being the country's largest bank, Jamie Dimon has a vantage point that stretches to every corner of the economy, both public and private. He writes eloquently about the American dream, the challenges we face, the changing nature of society, and proposes solutions where appropriate. You can even use the navigation on the left to skip all discussions about the bank. If you like this one, I recommend reading prior years' letters as well. They're timeless. (JP Morgan)
• Warren Buffett's annual Shareholder Letter is likewise required reading. It too was recently published. By virtue of the diverse businesses Berkshire Hathaway owns, from railroads to furniture stores, Buffett has an insider perspective on the country and its economy. You'll also find wisdom rarely voiced elsewhere: "Our country would have done splendidly in the years since 1965 without Berkshire. Absent our American home, however, Berkshire would never have come close to becoming what it is today. When you see the flag, say thanks." (Berkshire Hathaway)

Your Weekly Cocktail

An unexpectedly balanced take on The Last Word.

Final Ward

0.75oz Rye
0.75oz Green Chartreuse
0.75oz Maraschino Liqueur
0.75oz Lemon Juice

Pour everything into a mixing glass. Add ice until it comes up over the top of the liquid. Stir for 20 seconds (~50 stirs) until the outside of the glass is frosted. Strain into a coupe glass (a rocks glass will do if you don’t have one) and enjoy.

A fourth and final The Last Word variant, appropriately named the Final Ward. Invented by the same Phil Ward who has featured prominently in these letters as the brains behind the Division Bell and other well-regarded cocktails, this is perhaps the most famous of The Last Word takeoffs. It swaps out gin in favor of rye and lime juice in favor of lemon. What results is an unexpectedly balanced drink that marries the best of a whiskey sour and Last Word. Careful readers will have noted that I recommended stirring these variants rather than shaking. While shaking is the de facto standard for any cocktail involving fruit juice, I find that the resulting lower ABV and bubblier texture detract from the drinks. It's yet another way to play with The Last Word. Although I don't, you could even have some of these on ice (sacré bleu!).

With the original The Last Word, I set out to explore the extraordinary cocktail diversity that can be derived from a single source. We've covered the original and three variations and yet there are so many more. I hope it begins to illuminate for you the parallels between traditional cooking and drink making, how a cocktail can serve as a mother sauce with seemingly infinite variations.

Cheers,
Jared

1

Assuming a 30 second ad every 900 seconds is a 3.3% degradation in quality (30s / (15m x 60s)). An extra 5s is another 0.6%.

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