Netflix: The Red Menace

Just when Hollywood thought it had Netflix figured out, that "red envelope" company flipped the script, creating a playbook for any business that aspires to upend an industry. It's about to do it again.

"It's the creatives, stupid."

On the August evening that opens the Edinburgh International Television Festival, Kevin Spacey is giving the keynote speech, a jeremiad against his hosts delivered with all the fervor of a Tea Party populist railing against Washington.

The Oscar-winning thespian looks like a politician, his hair perfectly in place and his suit a somber charcoal. He emotes like a politician, too, as he launches into a withering takedown of the traditional way that Hollywood makes television, lambasting everything from the pilot process to TV executives ("those network people") who are always "sticking their fingers in creative decisions and having opinions about everything." And like the scheming pol he plays on House of Cards, the Netflix drama whose first season debuted in February 2013 and for which Spacey earned an Emmy nomination, Spacey offers his speech in silky soundbites uttered in his perfect, Juilliard-trained diction. It's the sweet sound of impending doom.

This firebrand futurist of television doles out praise to just a single company: Netflix. He credits the streaming-video service for daring to let creative talent run the show without interference, and for empowering viewers as well. "Clearly, the success of the Netflix model . . . proved one thing: The audience wants the control," he says of the streaming service's willingness to do such once-­heretical things as release all episodes of a season simultaneously. Viewers want "freedom," Spacey loftily proclaims. "If they want to binge . . . then we should let them binge."

Spacey hasn't always been so passionate about the future of TV--or even about Netflix. Indeed, back in early 2011, when House of Cards director David Fincher called him at his Malibu home with the news that Netflix was offering to guarantee to make and air a mind-boggling two seasons of the show without a pilot (at a widely reported $100 million), Spacey turned to his producing partner, Dana Brunetti, and whispered, "Does that mean we're going straight to DVD?" Back then, Netflix was still that company that mailed DVDs of mostly indie flicks to its customers in those convenient red envelopes. Now Netflix is the hottest player in Hollywood. In the creative community that drives that town, Netflix has stolen a step on HBO, cable's most pedigreed channel.

To hear Hollywood types rave about Netflix these days, you'd half expect to hear that the new phrase is "It's not TV. It's Netflix." Everything that makes Netflix's programming distinctive--surrendering control to creators, releasing all episodes of a season at once, keeping its viewership data private rather than participate in the ratings game--is a modern twist on the original, universally admired HBO game plan. Netflix even has more U.S. subscribers than HBO, surpassing the venerable network last fall when it reached 31 million, versus HBO's 29 million.

But Netflix is doing more than threatening HBO--what really has Hollywood worried is that the company seems in a hurry to redefine the very rules of the entertainment industry. Its willingness to sign up shows for entire seasons without first ordering a pilot (the one-shot episodes that TV honchos have for decades demanded before backing a show) has forced network executives to rethink a system that has defined television since its inception. And as the company has rolled out House of Cards, season four of Arrested Development, and Orange Is the New Black, Netflix's stock has soared--it almost quadrupled between January and Thanksgiving 2013. "There have only been a half-dozen shows," gripes one media executive, "and yet to read the press and hear the comments, you would think Netflix had found the cure for cancer."
,
In case you're wondering, Netflix has not done that. In fact, it hasn't really even revamped Hollywood. Take that idea of dealing a death blow to HBO, or, as chief content officer Ted Sarandos told GQ, "to become HBO faster than HBO can become us." Netflix may have edged ahead of HBO in U.S. subscribers, but HBO makes some $1.7 billion in annual profits for parent company Time Warner, according to the media analyst SNL Kagan, versus the comparatively paltry $100 million Netflix is on track to report for 2013. The largely acclaimed shows that Netflix has licensed may have helped it add almost 4 million subs through the first nine months of 2013, but HBO owns the majority of its shows, giving it a long stream of ancillary revenue (selling rights to other networks, merchandise, and so forth) that Netflix can only dream of.

Netflix has certainly benefited from Hollywood's paranoid vision of it as the red menace from that barbaric region to the north known as Silicon Valley. As one industry observer recently said, "Nobody knows what the hell is going on inside Netflix. And that's the way Netflix likes it." Being seen as an outside force armed with superior technology gives it a cachet that can't be matched by mere content providers. It also gives investors, who are partial to tech companies, a tale that might justify the potential they've now priced into the stock. But the real story of Netflix's Hollywood success is simultaneously less understood, simpler, and more instructive than the data-driven disrupter's tale that the company likes to peddle. (Netflix execs declined to be interviewed for this article, and encouraged talent, producers, and partners to stay mum.) Like all great Hollywood stories, it's got a final twist that brings it all together: If you want to disrupt an industry, you've ultimately got to beat it at its own game.

STEP ONE:


Wanna be a player? Behave like a player

On that fateful afternoon in 2011 when Spacey had doubts about Netflix licensing House of Cards, Dana Brunetti "pointed to him across the room and said, 'You're doing this deal. I'll explain it to you when we get off the phone,' " recalls the producer. "This was a chance to become the bellwether show for a brand-new network," says Modi Wiczyk, co–CEO of Media Rights Capital, which developed, financed, and produced House of Cards. "You want to be Mad Men on AMC. You want to be The Shield on FX." And then there was the money: $100 million. As scriptwriter Beau Willimon tells me, "It quickly became a no-brainer." In Hollywood, a no-brainer for one side in a negotiation usually means the other side got screwed. So why was Netflix willing to spend so much money?

On its face, Netflix's business is a simple one. As it wrote in its 2010 annual report, filed just a month before it announced the House of Cards deal, Netflix operates on the principle that "additional subscriber growth enables us to obtain more content, which in turn drives more subscriber growth." That can be a virtuous circle, but only if subscriber growth outpaces increases in content spending. That year, 2010, was the first in which CEO Reed Hastings expected subscribers to stream more content than they watched on DVD--which created a big problem, since ­licensing streaming content is more expensive than owning a lot of DVDs. The competition for streaming rights was intensifying; the studios that Netflix licenses movies and TV shows from were becoming more stingy, often keeping content for themselves and their own streaming services. A key partnership with Starz, which provided Netflix with blockbusters from Disney and Sony, was set to lapse in 2012. Furthermore, content costs were skyrocketing, swallowing up more than 50% of revenue. Renewing its streaming deals was only going to get pricier if Netflix didn't have some leverage.

Netflix needed to start differentiating itself with programming that couldn't be found anywhere else. This is what cable networks have done for years. But other Silicon Valley–based "disrupters" that have attempted this content play--Amazon, Hulu, Yahoo, and Google, to name a few--have ­assumed they could do it on the cheap. Says one agent, "Amazon aimed super low. That whole, 'Oh, let's vote on shows to see what works?' The plan is absurd." The final decisions are reputedly made by higher-ups in Seattle who are "better at selling rakes than TV shows."

Netflix, on the other hand, "aimed high from day one," says the agent approvingly. "Netflix said, 'Hey, David Fincher, Kevin Spacey, let's get the best writers in the business.' " From the beginning, the so-called disrupter played the Hollywood way: Hire big names and pay big bucks. Unlike Jeff Bezos and Larry Page, Hastings and Sarandos understood the psychology of the town. "They picked up House of Cards for two seasons to the tune of $100 million, and in Hollywood, that's real," adds one former cable-network executive. As Sarandos explained in a roundtable discussion with The Hollywood Reporter last fall, "At some point I said, 'Look, this is a massive bet. And if it doesn't work, it will be a super-expensive license, but we won't be in the originals business. And if it works, we'll be in the originals business.' "

Sarandos's wager seems to have been validated by the significant subscriber gains Netflix garnered in the first nine months of 2013 when it debuted four new shows. New members were up 15%. That went a long way toward paying for Kevin Spacey's Emmy-night tuxedo.

Sarandos, who is nothing if not dogged, has used the halo effect of its foray into original series to create a new model for Netflix at the bargaining table with studios. His deals with Disney (reportedly at a hefty price tag of $1 billion) and DreamWorks Animation gave Netflix access to a handful of premium movies. Later, either as part of those deals or as an outgrowth of the relationships, Netflix announced that it is developing original shows with these studios (in the case of Disney, with lesser Marvel characters, and with DreamWorks, a Turbo spin-off). These moves indicate that Netflix is now powerful enough to try to cherry-pick the content it wants from a studio's library, to push for more exclusivity, and to ask for more places to air what it buys. Netflix is in more than 40 countries around the globe. "Canada is important. Scandinavia. South America. They're asking for more territories and more stringent terms," says one source.

Nevertheless, the fact that it doesn't own its straight-to-series shows is something that still doesn't make sense to a certain slice of Hollywood. "It's a terrible deal for Netflix," says one former network executive. "To not even have a small equity piece of the content is asinine." But Hastings and crew are comfortable with what they're spending for content they don't own. They're in a land grab for customers, just like Amazon is in retail. For the time being, their metrics are not those of a Hollywood studio.

Step Two:


Be a 13-year overnight success

Reed Hastings is the face of Netflix, a stereotypical Silicon Valley–style leader making futuristic proclamations and reducing everything to a math problem as he lumps around in his rumpled khakis. But in Hollywood, it's Ted Sarandos who runs the show. A lifelong movie and television geek, Sarandos has been masterful in forcing Hollywood to treat Netflix like a significant part of the ecosystem. If every promising tech company wants a "Sheryl," meaning the equivalent of Facebook COO Sheryl Sandberg, to transform its business, then every would-be disrupter should want a "Ted" to help it navigate the industry it ultimately wants to dominate. "Ted wants to propel this business into being considered equivalent to a major movie studio," says one former Netflix employee. "He doesn't really come from the same mold as Reed Hastings. I don't want to say he's caught up in the Hollywood thing, but he definitely reveres it."

Sarandos's Hollywood trajectory was hardly predetermined. The son of an electrician and a stay-at-home mother of five, Sarandos grew up in Phoenix, where, he likes to say, the boob tube was his babysitter. A part-time job as a video-store clerk during community college (he eventually dropped out) propelled him into a career in the burgeoning home-video industry. He arrived at Netflix in 2000 with a mandate to buy content for the then-DVD-only service.

In the early days, the studios viewed Sarandos as just another rube. "We felt like, these guys just don't understand how deals work, or how the town works," says one former network executive who secured $200 million from Netflix without giving up very much. Sarandos fared better in the indie world, a natural fit since indie features were popular with Netflix's early adopters. He made Netflix a regular presence at Sundance and the Independent Spirit Awards, and made the company's acquisitions unit, called Red Envelope Entertainment, a notable, if small, player. The venture was a great way for Sarandos to forge relationships and hone his instincts. "The only move he had was to go after the independent community," says Gina Keating, the author of the corporate history Netflixed. "He was just not getting any traction with the majors." Sarandos helped release the Oscar-winning documentary Born Into Brothels and the Duplass brothers' first feature. A comedy nerd, Sarandos filmed a Zach Galifianakis comedy special in 2006, three years before The Hangover made him a movie star. Red Envelope enabled him to become close to major figures like the Weinstein brothers, who have made many deals with Netflix over the years. Their most recent one gives Netflix the rights to every Weinstein release starting in 2016 at an estimated cost of $30 million a year.

Sarandos's passion sets him apart from the typical Hollywood suit who only cares about box-office numbers and deal points. Beau Willimon, the screenwriter who was nominated for an Oscar for The Ides of March, recalls that during his first meeting at Netflix, Sarandos made a point of asking him if he would sign his House of Cards script for him. "It was incredibly flattering! He wanted that object to sort of mark that moment," says Willimon, before pausing. "Or it was an incredibly savvy business move to ingratiate himself. Or both! He is definitely one of the more savvy people out there. But every step along the way, he's been nothing but encouraging and excited." The smarts and enthusiasm have converted Hollywood, which now acknowledges Sarandos as one of its clan. "Ted embraces filmmakers," one agent tells me. "And if you're a big filmmaker or actor, and you have a real point of view and vision, if the head of the company embraces that, that's pretty powerful."

So while Netflix likes to trumpet its sophisticated algorithms and "regression models," claiming that they alone determine whether it green-lights a show, its real secret weapon may be Sarandos. Orange Is the New Black, for example, was far from a presold "sure thing": It had no stars attached and showrunner Jenji Kohan's Weeds had been only a modest hit on Showtime. Sarandos bought season two of the show before season one had debuted on the service. "Ted built his business on taste," Harvey Weinstein told the crowd at the Exploring the Arts Gala in L.A. last fall. "His good taste."

Step Three:


When everyone copies you, change tactics

Last September, Netflix took over the rooftop of the London Hotel in West Hollywood to celebrate the Emmys. "It was very classy, there were great views," Willimon says. "There were a lot of people there, but it wasn't a big, glitzy smorgasbord. This was for people who were close to the shows. Friends of Netflix." The night "gave them a ­legitimacy," says Mike Kaltschnee, the blogger who runs the site Hacking Netflix, "which is what they crave." True, HBO had taken home 27 Emmys to Netflix's 3, but the night confirmed that Sarandos had made Netflix part of the ­Hollywood firmament.

The more important validation came from how Hollywood was operating in a post–House of Cards world. The Netflix Effect was inescapable. When FX Networks ponied up a reported record sum, $750 million (or more), for the rights to air more than 550 episodes of The Simpsons on both its FXX Channel and FXNow mobile app, it smacked of a clear attempt to compete with Netflix. What better way to launch your late-to-the-party streaming service than with the ultimate feast for young men hooked on Netflix-style binge viewing?

Meanwhile, other rivals started ordering straight-to-series shows. Kevin Reilly, chairman of the Fox Broadcasting Co. and a longtime critic of the traditional development system, ­eschewed pilots when he ordered up a season of Hieroglyph, an Egyptian period drama, and Gotham, a pre-Batman origin story of the gritty city and its colorful criminals. HBO, the original un-­network, made True Detective, a buddy drama debuting in January starring Woody Harrelson and Matthew McConaughey, its first straight-to-series order in years. Sources at HBO deny that this had anything to do with Netflix, and say the script was simply that good. But by appearing to follow Netflix's lead, its rivals have unwittingly endorsed the streaming service's status as the new shot-calling alpha.

They've also expanded the power of creative teams, who now enter negotiations hoping to extract more money and larger episode commitments. When Todd A. Kessler, Daniel Zelman, and Glenn Kessler were shopping around their follow-up to Damages, they first went to HBO, according to two sources. HBO found the pitch interesting but half-baked. The team turned around and made a deal with Netflix, which immediately agreed to shoot 13 episodes. Says one TV producer who recently shopped a show to Netflix, "Am I happy to sell to Starz or Showtime and go through the development process? Absolutely. But would I like to go to Netflix and know that if they like the thing I'm offering them, they can say yes and we can talk about production? Of course that's better."

What few people realize is that Netflix only makes straight-to-series commitments "with existing formats that have written scripts and people attached and bibles [dossiers outlining every detail of a show's world and its characters]," this producer says, referring to Netflix's desire for complete packages. "So it usually has to be some project that either came loose or somehow was just standing there."

Furthermore, sticking to its straight-to-series strategy won't give Netflix the content it needs to justify its sky-born share price. With the exception of Ricky Gervais's Derek, which launched in September and has been universally panned, Netflix's slate was barren for nearly half a year. And given that there will be no media tsunami accompanying the second season of House of Cards, it's unlikely that the show will prompt as many people to subscribe as its premiere did.

Quietly, Sarandos is starting to pull back from the playbook that his rivals are now copying. According to sources, he has made a few "script-to-series" orders. Similarly, he's easing up on the bingeing, only rolling out the first five episodes of Turbo Fast, citing challenges with producing a season of animation all at once. Sarandos and his team, which has expanded with hires from Tom Hanks's and George Clooney's production companies, are hearing more pitches, something they once never did. Increasingly, Netflix is ­quietly ­becoming a traditional development orga­­nization while maintaining the cloak of an ­innovator. "Do they need to have 30 or 40 scripts in development, like HBO or Showtime? No," says one agent. "But will they stay as they are? No way." As one former employee notes, "Netflix is good at taking chances. When they hit a bump, they quickly make a change."

The stakes have never been higher. As of September 30, 2013, Netflix is on the hook for $6.5 billion of content, $5.6 billion of which it must pay out in the next three years. Sarandos has said he is doubling his production budget this year, and there has been speculation that Netflix will need as many as 30 original shows to feed Hastings's ambition to win between 60 million and 90 million U.S. subscribers. "If Netflix grows its customer base from 30 million to 75 million? Then they're golden," says Wedbush Securities analyst Michael Pachter, who's bearish on Netflix's stock. At $7.99 a month, that would put Netflix's annual U.S. revenue at roughly $7.2 billion (doubling the company's overall 2012 revenue of $3.6 billion). "But if they grow from 30 million to 45 million?" Pachter asks rhetorically. That would put domestic revenues at just $4.3 billion, which would mean, in his estimation, "they're screwed."

Step Four:
Take your rival's greatest strength--and do it better

Netflix's official story of how it hired Sarandos illuminates the company's gift for Hollywood-style mythmaking. Sarandos reputedly caught Hastings's eye after negotiating a then-­unprecedented revenue-sharing deal between his then-employer, the retail chain West Coast Video/Video City, and Warner Bros. Sarandos allegedly turned down Hastings's first job offer, saying that his company was in the middle of a difficult merger and needed him. To which Hastings shot back: "Well, Mother Teresa needs you in India feeding starving children. Why aren't you doing that?"

According to two sources, including Mitch Lowe, an early Netflix executive who would go on to create the DVD–rental service RedBox, Lowe was the one who wooed Sarandos, a friend and colleague, after running into him at the Video Hall of Fame dinner in 1999. At the time, Hastings wanted Lowe to move to L.A. to become the company's head of content, but Lowe was loath to leave the Bay Area. "You should take the job," Lowe urged Sarandos, who was reluctant. "I just don't know about the Internet," Sarandos confessed. "Is it going to last?" Ultimately, Lowe wore him down.

When I ask Lowe about the Hastings/Mother Teresa version of the Sarandos hire, he stares at me blankly. "Part of that may be true, but I just told you what happened."

Hollywood fancies itself as the cradle of storytelling, but these days no one's relating a more compelling and mysterious tale than Netflix. Like many Silicon Valley companies, it streamlines its story and tells it in a uniform way that serves the company, with or without an ounce of proof. "Every time a new series comes out, with the exception of Derek, Netflix says it's the most viewed show on the service, and no one ever challenges them," says one TV executive. "It's a little bit laughable that they can do that with every series and people write it." As another competitor gripes, "How can you say something's a freaking hit without a metric?"

The whines of rival network chiefs may not stir pity, but Netflix's decision to tout its data prowess while not revealing any of it has broader implications for the way Hollywood does business. At the Toronto film festival last fall, WME agent (and, ironically, former Netflix executive) Liesl Copland gave a buzz-generating speech about how digital companies like Netflix are actually hurting the independent-film market with their "analytic black holes." She said that data about how a film has performed on a digital platform is "the currency for how our projects ultimately get off the ground." So when a filmmaker is trying to put together a movie and can't present financial backers with any information on how his or her previous work has performed on a substantial platform like Net­flix, it puts them at a disadvantage. The same goes for talent agents renegotiating deals. Shouldn't an actor involved in a "hit" get a pay bump? But where's the proof it's a hit?

Netflix wasn't always this cagey. Back in its scrappy startup days, it openly shared information with the press and filmmakers. But after the company was lambasted for the Qwikster debacle in late 2011 (when Hastings made the ill-conceived decision to split the DVD business into a separate division with that horrible name), its distrust of outside scrutiny went into overdrive. Even Hollywood is kept more at bay. Agents and studios doing business with Netflix are asked to sign nondisclosure agreements. When a CAA agent discussed the cost of Netflix's original shows at a panel at UCLA last year, the company stopped speaking to him for a time, according to a source.

There's a clever strategy behind its secrecy: Hollywood is driven by numbers--Did a movie surpass $100 million at the box office? How many 18- to 49-year-olds watched last night?--and in the absence of such numbers, assumptions start being treated like gospel. When Breaking Bad creator Vince Gilligan gushed at the ­Emmys that Netflix was the reason that Breaking Bad was able to stay on the air, it was yet another pronouncement that everyone ­accepted simply because there was no data to disprove it. Except that past episodes of Breaking Bad have been available on AMC, DVD, and iTunes, and through TV Everywhere--and Netflix didn't start airing them until after AMC made a deal with Gilligan for the show's final season.

When Sarandos was asked by The Hollywood Reporter how long he could keep up the silence, he said, "Honestly, at some point, someone will just spend a ton of money getting the answer. Because you can, right? Somebody could sample 2,000 people, spend a million dollars, and get the data. It's a question of how valuable the answer is to you guys. It's not to me." This is utterly disingenuous coming from a company that claims that algorithms drive its content decisions.

A truer answer would have been something like, "We'll release the data when it's in our interest." For now, there's no good reason to open up, since Hollywood is so busy bowing to the power of the Netflix checkbook. "I know certain studios have said, 'Give me some data or we don't do the deal,' " says one source. "Netflix says, 'We won't.' And the studios finally say, 'Well, the check's more important.' Everyone's folding. Netflix has all the power because we let them, not because they have all the power."

The power of illusion is something Netflix has learned, of course, from Hollywood itself. As former superagent Michael Ovitz used to say, "Perception is everything." From hotel-suite-size corner offices to gilded press releases to asking talent for a cherished keepsake from a deal, the entertainment industry is built on gestures and touches that give it a mythical stature that distract the eye from the workaday grind of 60 takes, hard-fought deals, bitter competition, and broken dreams.

Hollywood's problem isn't that Netflix is playing a game it doesn't understand by rules it didn't invent. Hollywood's problem is that Sarandos, and Netflix, are beating it at its own game. If Netflix can continue to do so, while at the same time expanding its technological lead on other tech companies trying to break into the content game, that really would be some kind of, well, blockbuster.

[Models by Jethro Haynes | Photos by James Moriarty | Posters by Miles Donovan]

Add New Comment

10 Comments

  • What's the source for this: "there has been speculation that Netflix will need as many as 30 original shows to feed Hastings's ambition to win between 60 million and 90 million U.S. subscribers. "

  • I think the word 'speculation' sort of answers your own question.

    As for the US subscribers number, much of Netflix's financial projection and forecasting model is tied to hi-speed Internet subscription growth not production of new content.

    That said, I'd have to believe there are very few potential subscribers into TV or Film that new content would convince them of a subscription if they hadn't been already.

    60–90 million US customers is crazy talk. They could release exclusive footage of aliens landing at the birth of Christ and I think they'd still fall short of that number.

  • Nick Tapp

    "Success leaves clues". We can all learn a thing or two by taking a deeper look into how companies become disruptive and thoughtfully applying those steps to our own industries. Kudos to the author.

  • Jim Jones

    I think Gervais is really funny and clever, but I tried to watch the show and soon changed channels.