Photograph by Art Streiber for Fortune
How Netflix Became Hollywood's Frenemy
The streaming service is changing the way TV shows and movies get made—whether studios and networks like it or not.
It's 4:30 p.m. on a Friday, and Ted Sarandos is comfortably seated in an armchair in his Beverly Hills office, looking surprisingly well rested for a guy who has already spent 11 hours on an airplane.
The chief content officer of Netflix nflx has just returned from France, where he joined CEO Reed Hastings and actor Gérard Depardieu for the premiere of Marseille, Netflix's first original French-language program. Depardieu, a former heartthrob who has puffed up like a profiterole in recent years, plays an aging mayor in the election battle of his life in the eight-episode series. Critics, at least in France, haven't been kind to Marseille, which made its debut on May 5. "In refined language, this would be called an industrial accident," Pierre Sérisier wrote in the French newspaper Le Monde. "More colloquially, this is cow shit."
Whether Sérisier thinks Marseille is more merde than merveilleux doesn't necessarily concern Sarandos. After all, no one but Netflix (No. 379 on the Fortune 500) will ever know how the show performed with subscribers—the streaming-media company doesn't show up in Nielsen ratings or disclose viewership numbers. What does concern Sarandos is making sure the series ultimately gets more subscribers to sign up for the company's streaming service. Whether those customers are Francophiles in Mali (yes, Netflix is available in the French-speaking African country) or residents of the real Marseille doesn't matter much, as long as they sign up. "Great storytelling," Sarandos confidently tells Fortune, "is what makes something really global."
Photo: Stephane Cardinale—Corbis/Getty Images
Just a few years ago it would have sounded absurd for a Netflix exec to talk about what makes good storytelling. But these days the Silicon Valley interloper is arguably the biggest influencer in Hollywood. Netflix has harnessed the shock waves of the broadband revolution, becoming simultaneously one of the top-performing tech companies—its stock rose 134% in 2015, the best return of any Fortune 500 member—and one of the world's fastest-growing entertainment businesses. It's spending $5 billion this year on television and film content, a spree that far outpaces its rivals—and underscores the pressure it's exerting on those rivals to rethink the way they operate.
Netflix's refusal to make viewership numbers available has thrown a wrench into television's ratings-driven business models. Its pioneering practice of buying up an entire season (or two) of a series without requiring a pilot is luring writers, actors, and producers away from traditional television. And by releasing full seasons in one fell swoop and streaming them ad-free, Netflix has trained viewers to binge—and to be increasingly impatient with once-a-week episodic television and commercial breaks.
And that's just what's on TV. Netflix is encroaching on the big screen too, outbidding incumbent studios for high-profile projects like Bright, a Will Smith cop thriller it snapped up for a reported $90 million this year. More alarmingly, it has been lobbying against traditional theater-only cinematic runs for new movie releases—leading John Fithian, CEO of the National Association of Theatre Owners trade organization, to call out Netflix at a recent conference as a "grave threat to the movie business."
For now it appears that the Force is with Netflix, both figuratively and literally. (In May the company announced the details of an exclusive distribution deal with Lucasfilm owner Disney dis .) In April, Netflix announced it had passed the 81-million-subscriber mark, an increase of 35% from the year before. The company dominates media streaming at a time when viewers are migrating away from other modes of watching TV and movies. In the last quarter of 2013 traditional pay services from cable, satellite, and telcos added 79,000 customers; in the last quarter of 2015 that same group lost about 49,000. Viewership of traditional television is on the decline, while movie attendance has mostly flatlined, despite a small uptick last year. In 2015 nearly a third of the population of North America didn't set foot in a theater; another 10% went only once.
Netflix might arguably be categorized as more of a beneficiary of these trends than a cause. But if moguls blame the company for their woes, its executives don't mind the controversy. In their view they are just fixing what is broken. "We don't think of it as trying to do things differently," CEO Hastings tells Fortune during an interview at the company's Los Gatos, Calif., headquarters. "We think of it as trying to do things well."
It's not the first time that Netflix, No. 379 on this year's Fortune 500 list, has proved an existential threat to the status quo. "Blockbuster was in the Fortune 500," Hastings says cheekily. The half-joking dis—the now-defunct Blockbuster was the one-stop shop for movie rentals before Netflix and its red DVD envelopes came along—is telling. Netflix won't stop until it wins. But that doesn't mean it can't shoot itself in the foot trying. As it forges ahead, transforming itself into a bona fide entertainment company, its success is still predicated on its coexistence with the very environment it is trying to disrupt: the Hollywood ecosystem.
I learned the word 'frenemy' in this town," says Sarandos. "I think Les Moonves is the one who said that word to me the first time."
The longtime Netflix exec has earned the right to drop a name (in this case, of the CEO of CBS cbs ). He has also earned the "frenemy" label. For years Sarandos was tasked with cutting licensing deals with studios and networks—helping those content creators make more money from their catalogues. Then he decided to compete with them. Since 2013, under his direction Netflix has partnered with the likes of Tina Fey, Chelsea Handler, and Kevin Spacey to create headline-grabbing original series for the web-based network.
That role has elevated Sarandos's profile, to a level on par with that of the much-lauded Hastings. (Google "Reed Hastings and Ted Sarandos" and you'll get an unending stream of pics of the two together at premieres and press events.) Hastings, 55, is a computer-science grad turned serial entrepreneur. He started Netflix as a mail-order DVD service in the late 1990s after Blockbuster fined him $40 for a late movie. Sarandos, 52, was an ambitious college dropout from Arizona who got his start running a chain of video stores and talked his way into Netflix soon after it was formed, joining in 2000 as vice president of content.
Handler: Mathew Imaging—Wireimage/Getty Images; Elba: Randall Michelson—Wireimage/Getty Images; Spacey: Charbonneau—Rex Shutterstock via Zuma Press; Kohan: Jesse Grant—Getty Images
Hastings calls their working relationship "incredibly easy and fluid," but their demeanors and dispositions hint at the differences between Silicon Valley and Los Angeles. In separate interviews, they donned similar outfits: plaid button-down shirts and jeans. But Hastings wore sneakers and a shaggy goatee; Sarandos was clean-shaven and in loafers. Hastings met me in an open-plan space at HQ, with engineers and other employees milling around us; my interview with Sarandos was behind the closed doors of his spacious office.
About 600 employees now work for Sarandos out of the company's Beverly Hills location, and Netflix will more than double its L.A. real estate when it moves into a Hollywood office tower in 2017. But it took some trial and error for Sarandos to earn that kind of headcount. In 2006 he persuaded Hastings to let him start Red Envelope Entertainment, an initiative to buy and distribute indie films on DVD. The division flopped and shut down two years later. One problem that tripped it up: Under U.S. law, there were no "exclusives" in DVD distribution. No matter how much Netflix spent to buy, say, a movie about a road trip to pick up a lounge chair (yeah, we didn't see The Puffy Chair either), others could turn around and distribute it just as easily.
By 2011, Netflix was four years into its web-based streaming and had amassed 20 million streaming subscribers. That's when Sarandos decided to try his hand again, this time with a much more ambitious play. He shelled out a reported $100 million to buy the domestic rights to House of Cards, a virtually unknown British miniseries that had run in 1990. Hastings's only contribution, the way he tells the story, was not stopping it. Two years later the show launched to massive fanfare and acclaim—opening a Pandora's box of change.
House of Cards, starring Kevin Spacey as the unctuous and deadly politico Frank Underwood, is so much a part of the cultural wallpaper—it will start its fifth season in early 2017—that it's easy to forget how revolutionary it was. When Netflix bought the rights, it cinched the deal by offering the show's producers, including Spacey and director David Fincher, a commitment for two full seasons, sight unseen. There was no demand for a pilot, no test-marketing song-and-dance to perform. Those testing processes are agony for "creatives," but they enable TV networks to manage their financial risks, test-driving an idea until they're confident it will make money.
The House of Cards deal tossed that model out like so many catered leftovers, as Netflix bet on the product without insisting on the creative control that comes with a traditional TV deal. "No one had done that before," says Matt DelPiano, an agent with Creative Artists Agency who represents Spacey; for the creators, he adds, saying yes "was a no-brainer." Netflix also made House of Cards the first "binge-watch" series by releasing an entire season at once—an approach that has since taken off and been experimented with by networks and by newer competitors like Amazon and Hulu.
The show was the first of many big-ticket Netflix bets on original programming. Many network executives complain that Netflix's largesse has driven up the cost of the best talent. They note that for a network show to justify a $50-million-a-season price tag, it would have to command almost unattainably big audiences.
Photograph by Art Streiber for Fortune
But Netflix doesn't face the same constraints, thanks to its subscription model. Each Netflix membership starts at $8 a month, or $96 a year. Multiplied by tens of millions, that revenue stream gives Netflix a huge cushion to support prestige programming. Sarandos and Hastings are cagey about how Netflix chooses which shows to green-light, though they have said that data about current subscribers' viewing habits shapes programming. More important, as Sarandos stresses, "it's the cumulative impact of a lot of great programming that really moves subscriber growth." Recent years' numbers bear that out: The company's surge in original programming has coincided with a 145% increase in subscribers since 2013.
Thanks to subscriptions, of course, Netflix can forgo commercials. Sarandos and Hastings argue that since they sell no ads, they don't need to disclose viewership numbers. That assertion drives competitors nuts. At a Television Critics Association event in January, network heads spoke out against Netflix's shroud of secrecy. John Landgraf, the CEO of FX Networks, called its lack of disclosure "ridiculous" and accused tech companies of not playing on an even field.
It's hard to blame the networks for feeling frustrated. Non-streaming TV viewing in the U.S. fell about 3% last year in terms of hours viewed. Analyst Michael Nathanson of MoffettNathanson has estimated that Netflix accounted for about half of that decline. (He calculated that Netflix represents about 6% of American TV viewing and projects that will rise to 14% by 2020.) Those trends eat into networks' ability to command top prices for advertising, while the lack of numbers from Netflix makes it harder for them to prove that their hits are tops in their categories. The situation gets more galling when Netflix executives state, without offering proof, that they are beating the networks, as Sarandos did last December when he said that Netflix's drug-trafficking drama Narcos reached more viewers than the HBO hit Game of Thrones.
Netflix has little incentive to make peace by divulging its numbers, Sarandos says. "If I told you today that the shows on Netflix were watched at a dramatically higher rate than anything on basic premium or broadcast TV, that would be bad for our suppliers, because everyone would say, 'Oh, my God, Netflix is killing all of television,' " he says. "And if I told you the opposite, they'd say, 'Oh, my God, Netflix is going to die.' "
Even movie stars—and Netflix is signing up a dizzying bevy of them—won't know how their films do on Netflix. What will Sarandos say if Will Smith demands to know how many people have seen his movie? Sarandos delivers his hypothetical answer with just a hint of a smile: "No."
Then again, Smith may not care, since he'll be cashing an enormous check—thanks to Netflix's next big programming push, into feature films. When Smith's Bright makes its debut, it will be Netflix's boldest bet on an original movie to date. The reported $90 million price tag is a hefty one—even for the former Fresh Prince of Bel-Air and director and writer David Ayer, of Fury and Training Day fame. But Hastings and Sarandos are focused on proving that Netflix can produce exclusive, big-ticket films with franchise potential. (In other words, it'd be wise to wager on a Bright 2.)
The Bright bonanza is part of $5 billion that Netflix will spend on programming this year alone, including at least 60 original shows, a dozen documentaries, and eight feature films. It's an enormous upping of the ante: To put it in perspective, Netflix spent $3 billion on programming in 2015, and its total revenue for 2015 was just $6.8 billion. (To help support its content habit, Netflix has raised long-term debt, closing a $1.5 billion borrowing round last year.)
In addition to Bright, Netflix recently bought a war-movie satire by Brad Pitt and a drama about a Cambodian human-rights activist, directed by Pitt's wife, Angelina Jolie Pitt. Netflix's appeal to Brangelina-caliber stars is growing thanks to its huge subscriber base, but also because the company offers a simplified compensation structure that takes out some of the risk of moviemaking. Typically, top movie talent negotiate a cut of the "back end"—what a studio makes from box-office sales, global distribution, and syndication. That can leave stars and directors vulnerable if a movie flops. But Netflix replaces back-end deals with generous payments upfront, something it can more easily do because of its subscription income.
What's causing heartburn in Hollywood is the thought that Netflix may never put these films on the big screen. Hastings has long squabbled with the industry over the "theatrical window"—the amount of time that theaters have exclusive rights to a film. Until Netflix came along, no one in the business thought you could completely do away with it, and many still don't. "We believe that movies made for the cinema are different than movies made for home content," says Fithian, the head of the theater owners' trade group. "Consumers think that if a movie is available at home at the same time as the cinema, it must not be that good."
Netflix has been just as outspoken, claiming that theater owners are stifling innovation. A smaller window, or a nonexistent one, would give Netflix and its subscribers faster access to first-run movies. And if Netflix were to make streaming-only movies that generate blockbuster-style buzz and audience interest, more studios might consider taking a chance on earlier streaming of their own movies.
Photo: Kevin Winter—Getty Images
Sarandos rebuffs the idea that smaller windows would kill the theater industry. "Remember, you can eat at home any meal that you can eat out," he says. "But people choose to go out." Left unspoken is the fact that where movies are concerned, "eat at home" has been winning market share for quite a while—thanks largely to Netflix.
How big can Netflix get? In January the company announced that it is now available in 190 countries, up from 60 a year earlier. About 42% of Netflix's current customers are outside the U.S. The global growth hasn't rolled out as fast as investors had hoped, resulting in some recent yo-yoing of Netflix's stock price—but some analysts think the company could still double its customer base by 2020.
"We haven't had nearly as much impact as we hope to make over time, because we're not nearly global enough," says Hastings. "If we can get to that level of popularity globally, we'll look back at today and say, 'Oh, we were so small, 81 million only.' "
As it expands, Netflix's ability to work with the competitors that now eye it so distrustfully will be more important than ever. Judging by one of its latest deals, that may not be a stretch. In May, Netflix announced that it was partnering with Univision to develop a series about drug lord Joaquin "El Chapo" Guzman. The deal will also bring two original Netflix shows, Narcos and Club de Cuervos, to the Spanish-language network. Yes: In its quest for global domination, Netflix will try "traditional TV," including making its shows' ratings visible for all the industry to see. Worlds colliding? In Netflix's universe, it won't be the last time.
Correction: An earlier version of this article erroneously attributed a quote by Ted Sarandos, Netflix's chief content officer, to Reed Hastings, its CEO. The article has been updated and corrected.
A version of this article appears in the June 15, 2016 issue of Fortune with the headline "The Outsiders."