Netflix's secret sauce for acquiring content

If you're a Netflix subscriber, you should be happy with the sounds coming out of Hollywood.

One entertainment executive told me last week that other Web video companies looking for content should use Netflix as a model for how to work with the major studios. He called the company a "good partner," high praise coming from an industry in which few have anything good to say about Internet companies. This bodes well for Netflix's chances of obtaining more streaming content. When it comes to the studios' complaints about Netflix, there's also something positive to be found.

"While there are things in the Netflix system that are clearly cannibalistic [to sales], there are things we can change," Craig Kornblau, president of Universal Pictures' home entertainment unit, said during a conference appearance earlier this month. "They can pay us more, or we can reduce the quality of what we give them."

Kornblau obviously doesn't think that Netflix paid enough for content it licensed in several high-profile deals with the studios this year. That may mean trouble in the future, but Kornblau's statement, coming so soon after Netflix landed the licensing agreements, also suggests that the company's ability to acquire content isn't solely dependent on the size of its checks. Netflix appears to have more to bargain with than just cash.

The hit rental service is now the supreme power in U.S. video rentals. It has put itself in that position by building one of the most loyal followings and strongest brands of any digital-entertainment company. Netflix is respected by consumers for doing away with the much-loathed late fees, offering low prices, and providing one of the best viewer experiences online. Netflix has also stood out among Silicon Valley companies for its willingness to partner with the studios.

"It's not just about writing the big check," Ted Sarandos, Netflix's chief content officer, said in a recent interview with CNET. "A lot of people have written big checks and didn't get what they needed."

One of the best stories in digital entertainment this year is how Netflix built up its streaming-video library against the odds. It wasn't long ago that pundits predicted that Netflix would be unable to pay the studios' rates and would see its supply of streaming content cut off. The naysayers argued that Netflix would go bankrupt or alienate subscribers by forcing steep price increases on them.

So far, the company has defied the doubters.

Embedded in Hollywood
For tech companies, acquiring rights to film and TV content has proven to be a challenge. For instance, the four major broadcast networks have blocked Google TV from accessing their Web content. To some studio insiders, the Silicon Valley guys were just the latest hustlers to come to town. The Web video companies were either devising software or sites to pirate or port in films and TV shows, or were dismissive of the studios' digital strategies. YouTube employees once famously referred to the video portal created by NBC Universal and News Corp. as the "clown company." It turned out to be Hulu.

A high-handed attitude isn't what Reed Hastings wanted. Netflix's CEO, named "Business Person of the Year" last week by Fortune magazine, handed Sarandos a very different mission in Hollywood.

"Unlike the companies that [tried to strike partnerships with the studios] before, we didn't make the mistake of relegating relationships to agents and lawyers to broker deals," Sarandos said in a recent interview with CNET. "The same way we don't outsource our [intellectual property], we don't outsource our relationships...It's our goal to be embedded into the studios' business and understand what drives their decision making. We do our best to be good partners."

The close Hollywood ties help Netflix managers find ways to help the studios, as well as themselves. One example involves the recent decline in sales of DVD box sets. Many TV shows aren't selling well on DVD, even as the costs of producing one-hour serialized shows go up, Sarandos said. When it comes to syndication, a dramatic series that includes more adult themes, such as Showtime's "Dexter" or Fox's "Lie to me," are traditionally a tough sell. One issue with most serialized shows is that if viewers miss an episode, they fall behind in the story.

Netflix's streaming service is one solution. Users don't have to worry about falling behind. They choose which episode to watch and when.

Netflix also impressed many at the studios by agreeing to help protect DVD sales. Earlier this year, the Los Gatos, Calif.-based company agreed to delay renting some of the studios' newly released DVDs until 28 days after their titles hit store shelves. In return, Netflix received access to more TV shows and films for its streaming service.

Blockbuster and Netflix data
There are other, more practical reasons for strong Netflix-Hollywood ties: Blockbuster is all but gone. The brick-and-mortar retail chain, which filed for Chapter 11 bankruptcy protection in September, was a big source of revenue for the studios. And just as DVD sales plummet, Hollywood's attempt to persuade consumers to upgrade film collections to Blu-ray discs has largely failed. The studios know that Netflix, with its 17 million subscribers, can help fill these holes.

More importantly, the studios know the trend in renting movies is to do it online. If there's a better way than Netflix for the studios to stake out prime digital turf, it hasn't presented itself.

And then there's all that customer data. Eric Garland, CEO and co-founder of Big Champagne, a company that tracks digital-media consumption, argues that Netflix's greatest advantage--indeed, one of the things that appeals most to Hollywood--is what it knows about its customers' renting and viewing habits.

"Netflix is cleaning up because they started seeing changes in consumer behavior before consumers knew they changed their behavior," Garland said. During the period before it started offering streaming content on demand, for example, Netflix noticed that its subscribers had already started to slow down the volume of their DVD viewing.

"We were updating the queues, we were creating the lists, but that ping-pong of DVDs going back and forth in the mail had started to slow. You didn't know what that meant. You were busy going 'Ah, I need to watch that DVD, but I don't want to watch it tonight.' You put it back down. What they saw was that you needed better and more immediate access to more titles," Garland said. "That's old news now, but they've been in possession of that for years. So the reason that Netflix is of such strategic value to Hollywood is that they already own the new consumer who doesn't want to bother with the disc."

Correction 8:37 a.m. PT This story incorrectly stated the number of Netflix's subscribers. Netflix currently has 16.9 million subscribers.