Let’s start by defining disruption. I’m not using it in the popular way, but rather how it was defined decades ago by Clay Christensen.
Disruption is when a company starts out by offering something that the incumbent’s most demanding and profitable customers view as significantly worse. However, the new offering appeals to overlooked, less profitable customer segments. The appeal comes from offering a new form factor that is more suitable to the incumbent’s less profitable customers. The new form factor then also appeals to people who were so poorly served by the existing offering that they previously weren’t customers at all.
Because the incumbent is focusing on serving its most profitable customers, it is slow to react. In the meantime, the new company rapidly improves the disruptive product to make it also appeal to more demanding customers. By the time the incumbent’s most demanding and profitable customers begin to leave for the new offering, the incumbent has lost.
Netflix has been a disruptor twice in its history. First it disrupted incumbent home video rental companies, such as Blockbuster. Initially most of Blockbuster’s customers viewed Netflix as worse because they had to wait to get a DVD and deal with the hassle of returning the envelope in the mail. However, for those that wanted more selection and were willing to wait, and often pay less, Netflix was great. The combination of fast shipping, improved selection, and no late fees eventually won over many of Blockbuster’s core customers.
Once the internet got good enough to enable streaming, Netflix went after movies and linear TV. Initially most moviegoers perceived watching a movie on Netflix as way worse than going to the theaters; some still do. Likewise, initially the most demanding TV watchers could not find what they wanted on Netflix. However, for those who wanted to watch older or more obscure movies and TV shows at a cheaper price, Netflix was a great fit. As Netflix started adding better and better movies and TV shows, and as home-viewing technology improved, mainstream moviegoers and TV watchers have increasingly realized that Netflix is more than good enough for their entertainment needs.
Netflix now has its sights on video games. Somewhat like streaming was to DVDs, gaming and other entertainment forms are a substitution threat to movies and TV. Here’s what Netflix co-CEO Reed Hastings said about the problem in an Wired interview last year:
When we look at the future, someday series and films may be like the novel or the opera, sort of a very small art form. What are the things that might outcompete movies and series? One would be user-generated content like YouTube or TikTok. Another might be new hardware-assisted AI/AR, you know scenarios. Another might be video gaming. So these are all potential substitution threats.
We know how to compete directly against HBO Max and Disney+, and that’s great and hard and interesting and fun. And then there’s these substitution threats where getting into their business is not a good way to compete with them because we won’t be as good at them. But for now movies and series seem very strong, seem like a core human format. Remember that movies have been around for over 100 years, continue to grow; TV series for 60 years now and continue to grow. So I think we’re onto a pretty long-term thing. But at least in principle, someday movies and TV shows will be small.
For what it’s worth, Hastings has been publicly addressing this problem for at least five years. He gave three interviews in 2016 making basically the same comments. See here, here, and here. (The second and third interviews are particularly good.)
The reason disruptive innovation works is that the disruptor doesn’t take the incumbent head on. Hastings acknowledges this when he says that “getting into their business is not a good way to compete with them because we won’t be as good as them.” Netflix can’t go head to head with Tencent, NetEase, and Activision Blizzard in video games. So how is it going to compete? The same way it competed against Blockbuster and legacy media companies like Disney and HBO: by following the disruptive innovation playbook.
Gaining a Foothold
Christensen makes clear that disruption can start in two ways. The product has to provide existing less demanding (and less profitable) consumers with a more suitable product, turn non-consumer into consumers, or both. Basically, the goal is to make something that appeals to customers or would-be customers that are poorly served by incumbent companies.
Viewed through this framework, I think Netflix’s initial focus on mobile games makes complete sense. As popular as video games are, there are a lot of people who either barely play them or don’t play them at all. These are the people Netflix is after. So, Netflix is going to have to make its mobile games super easy to play.
Easy-to-play mobile games are of course nothing new. The big difference with Netflix is it won’t have to monetize its games using in-game payments or ads. Netflix’s only goal will be to get members to enjoy (and play) the game as much as possible. It’s kind of like the difference between streaming video on demand versus showing movies and TV shows in theaters and on linear TV; the monetization model is totally different. Netflix COO Greg Peters highlighted the benefits of this model on the Netflix's most recent earnings call:
We also feel that our subscription model yields some opportunities to focus on a set of game experiences that are currently underserved by the sort of dominant monetization models and games. We don't have to think about ads. We don't have to think about in-game purchases or other monetization. We don't have to think about per-title purchases. Really, we can do what we've been doing on the movie and series side, which is just hyper laser-focused on delivering the most entertaining game experiences that we can. So we're finding that many game developers really like that concept and that focus and this idea of being able to put all of their creative energy into just great gameplay and not having to worry about those other considerations that they have typically had to trade off with just making compelling games. So those are some of the core things that we're excited about and think that can make this effort for us special even in the world of games.
He’s straightforwardly telling us that Netflix’s business model allows it to focus on serving underserved markets, which is exactly what the disruptive innovation playbook prescribes.
After gaining a foothold with customers or would-be customers that are poorly served by incumbent companies, the second step is to improve the product so that it appeals to mainstream customers. With Netflix, this would mean success in basic mobile games would be followed by increasingly complex games, both in mobile and on the TV.
I think TV will be much harder for a few reasons. First, to really be successful it would almost certainly require additional hardware, probably akin to what Google Stadia uses. Netflix could give this hardware away for free as part of the subscription, but even then there’s the additional step of customers having to plug in a USB stick or something similar. Second, a lot of gamers are already super happy playing against their friends on Xbox and PlayStation, which themselves are already offering subscription services. So how does Netflix compete with Sony and Microsoft?
The biggest benefit Netflix has in this regard is the built-in network of people from its membership base. If Netflix has over 300 million memberships in five years and there are on average two people per membership, that’s a network of over 600 million people. I suspect this is the biggest reason Stadia has been a failure so far, despite having really nice hardware and software. It’s really hard to crack the Xbox and PlayStation network effects.
The other difference between a Netflix TV-gaming service and Stadia is that the games on Netflix would all be free (zero additional cost). Stadia still uses the same model that’s been used for decades, where gamers pay up to $60 for a new game. This model obviously keeps out a lot of would-be gamers and prevents people from trying new games. Netflix would also differ from Xbox and PlayStation because there would be no additional cost to play games online with your friends. If a service offers online multiplayer games at zero additional cost, and there’s a built-in network of other people playing them, I think non-gamers or casual gamers are much more likely to try it out.
Will Netflix succeed in gaming? Who knows. As a shareholder, I hope so, but I’m also not counting on it. Making good games is really hard -- a lot harder than making good movies and TV shows. As Amazon and Google have found out, having virtually unlimited resources is no guarantee of success, especially for so-called “AAA” games that appeal to gamers furthest upmarket.
Of course, Netflix doesn’t have to make the games itself. As Peters said on the most recent earnings call, Netflix can license them -- though like with movies and TV shows, they’ll aim to offer “Netflix original” games:
We'll also do licensing because we -- just as we've done in that sort of other genre expansion, it's a great way to increase the volume of the offering that we have at the start to learn more quickly. And then as our internal production sort of scales, we can focus the energy on what we're learning in that regard.
One difference between what Netflix may do and what Amazon and Google have tried is that Netflix isn’t necessarily going to be making the games in house. I know Peters used the term “internal production,” but I don’t take that to necessarily mean an in-house studio or development. Rather it could simply mean that, like with movies and TV shows, Netflix bids on projects from external development teams. In other words Netflix would essentially act as a gaming publisher, with the development companies kept separate.
I suspect this set-up might appeal to a lot of game developers without their own publishing arm. Netflix might be willing to pay a lot more, too. The bigger question mark in my head is how the more scaled companies that also act as publishers will take to Netflix’s propositions. Maybe Netflix will just license their content at first, offering a check so fat that even Activision or Take-Two can’t refuse. I’m guessing this would be similar to whatever arrangement publishers have with Microsoft and Sony for Xbox’s and PlayStation’s subscription services.
Overall, the long-term goal on the supply side, for both TV and mobile games, would be to give developers a win-win: better monetization and, particularly on mobile, the ability to create gameplay unfettered by any consideration other than making the best game possible. Of course, there’s also the benefit of being able to easily get your game in front of the biggest audience possible. If Netflix can use these supply-side advantages to offer great games, I don’t think it will be hard to get members to play them.
Yes, Netflix can disrupt gaming. Netflix’s subscription service, scale, and built-in audience creates a potentially superior model that could be a win-win for game developers. It also gives Netflix the perfect starting point to create games for nongamers or gamers that are poorly served by existing companies. If Netflix can succeed in this first step, it can then increasingly offer games that appeal to more mainstream gamers. If current mainstream gamers start playing games on Netflix en masse, then Netflix will have disrupted the gaming industry.