Hand Of Schumpeter Behind The Changing Fortunes Of NETFLIX

Article by Ashish Rajadhyaksha at  Entreprenuership Central

I was on a short vacation earlier this week, and turned on CNBC on Tuesday with the main headline that Netflix stock futures were down 35%, and all the pundits were talking about the loss in its subscriber base and increased input costs due to more expensive content contracts.  How fortunes of companies change in a fairly short duration?  Only recently Netflix stock was a serious high flyer, and could do no wrong, and now it was down precipitously on announcement of loss of 800,000 subscribers.  What happened?

Clearly its recent announcements of charging higher prices and carving out the streaming content into a separate business from its more traditional “mailing DVD’s” and watching movies online business didn’t sit well with its current customers.  Big surprise there!  Customers who were used to paying low monthly fees were now being asked to shell out more cash for the same service, and guess what they started leaving.  I suppose the executives at Netflix forgot about the secret hand of Joseph Schumpeter, and his idea of Creative Destruction that has influenced the field of Entrepreneurship, Innovation and Capitalism over the past 50-60 years.

Originally coined by Karl Marx, the idea more associated with the Austrian economist Joseph Schumpeter from his book Capitalism, Socialism and Democracy, essential elements of creative destruction are:

1.       Capitalism is a process of transformation and evolution that accompanies radical innovation and creativity where old ways of doing things get destroyed;

2.       Entrepreneur and his or her zeal and innovation is the main force behind sustained long-term economic growth, but it destroys established models that previously enjoyed near monopoly pricing power achieved through technological, organizational, and regulatory management prowess;

3.       A continuous evolutionary cycle develops where successful innovation creates temporary market power, eroding the profits and position of old guard firms, but ultimately succumbing itself to the pressure of new inventions developed by yet another competing entrants;

4.       Creative destruction causes short-term economic disruption and distress for workers whose skills may become outdated very quickly;

Success of capitalism will lead to a form of arrogance, corporatism, elitism with values hostile to capitalism, change and entrepreneurship, especially among intellectuals. The openness needed to allow entrepreneurship to thrive will not exist in advanced capitalism, and will soon be replaced with resentment, socialistic ideals of equality and fairness.  Isn’t that what’s happening with Occupy Wall Street protests where educated, unemployed people are protesting against banks and the wealthy due to their own worries about permanent loss of their quality of life?

So where does that leave Netflix?

Netflix pretty much ate Blockbuster and other movie rental companies’ lunch by replacing the need for consumers to go to a store to pickup movies with a simple envelope that could be dropped in the mail at a low, flat monthly fee to watch unlimited movies.  Then they gradually introduced online and on-demand, streaming movie watching experience that Blockbuster didn’t offer, and became an industry standard, and resulted in Blockbuster selling itself to Dish Network.  While Netflix was successful in changing the status quo thorough its’ innovative, price competitive product offerings, it still only was a distribution company, somebody else owned the underlying content.

Few years ago, all the old media companies and movie, TV studios were concerned about losing power to internet providers and made cheap deals with Netflix, giving it a huge advantage over its competitors.  Similar to how people expected NY Times and other newspapers, magazines to vanish due to shrinking ad revenues, investors and pundits assumed that this relationship inequity would last forever.  But concepts of vertical integration and creative destruction have their own way of rebalancing economic order.  The movie, TV studios and newspapers like NY Times own their underlying, invaluable content and perpetual rights that could be distributed in a variety of ways either by acquiring or creating their own distribution network or partnering with someone like Apple’s iTunes or Goggle’s You-Tube or Amazon’s Kindle to create an alternative distribution channel that’s disruptive to Netflix model.  Where Content is King, this innovative, entrepreneurial loop that gets created in the process is what creative destruction and economic progress is all about; disturbing the status quo and rationalizing the outsized profits.

Conclusion: Similar to how PC’s destroyed the main frame business, online jobsites changed recruitment process forever, product and service innovations change consumer behavior and motivation.  Today’s leaders become tomorrow’s laggards, but that doesn’t mean they cannot become leaders again.  Sitting on your laurels isn’t an option; both individuals and companies have to be nimble and watchful of their competition for both incremental and disruptive innovations.  Netflix stock is still a little pricey for a potential acquirer, but that market cap has shrunk substantially recently.  A little more bad news could start making it very attractive for Mr. Sumner Redstone of Viacom or Mr. Jeff Bewkes of Time Warner.  Let’s wait and see what happens over next 6 months to a year.

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