Why Netflix struggles?

Netflix was gaining so much momentum that it felt like they were going to take over the world and change Hollywood forever.  Their stock soared to an all time high of $298 in the summer of 2011 valuing the company at close to $20B.  They had a stunning subscribers growth from 10m (Q2 2009) to 24m (Q2 2011).   So why has Netflix struggled recently with subscribers leaving and their stock plummeting?

Despite all the media noise putting the blame on the way management handled the price increase and the qwikster debacle, we forgot to ask the question as to why they were doing those things in the first place.  To answer this question, we should look at the cable/pay TV industry that Netflix is disrupting.

  • Comcast – represents 22m cable TV subscription with annual revenue of roughly $36B (not including NBC Universal).  Comcast also has majority ownerships of a number of cable program/channel companies (i.e.: USA, SyFy, CNBC, etc), Universal pictures, and NBC TV network and broadcasters.
  • Time Warner Cable – revenue of $20B.  Their parent company Time Warner owns movie studios who produce hit movies such as Harry Potter and other cable channels such as HBO.
  • Direct TV – revenue of $21B.  Liberty Media (owner of Starz channel and others) owns controlling stake of Direct TV.
  • Dish Network – revenue of $13B.  Dish also owns Blockbuster movie on demand subscription that are *only* available for Dish’s subscribers.

If we ignore the rest of the cable/satellite TV providers (i.e.: Cox and other smaller players) and just combine these 4 giants, this is a $90B plus industry.  A significant portion of the $90B pie goes to cable channels (Starz, USA, CNBC, etc), Broadcast TV networks (NBC, ABC, FOX, etc), and movie studios that supply the programming.  The ownership structure in this industry ensures money flows between entities that are owned by the same person or group.  This creates a powerful force in the value chain that prevents outsider or new player to enter and disrupt the industry.

Netflix offers valuable on-demand movie services at a fraction of the cost of subscribing to cable/satellite TV channel.  Netflix has premium movie contents with their Starz Channel along with older movies and TV shows for $8/month.  Their offer is so compelling that the power of references and word of mouth propelled them to insane subscriber growth for a period of time.  Consumers suddenly see a significantly lower cost alternative for their $80/month cable bill and opt for Netflix instead.

The success annoys the cable TV industry because Netflix’s gain is their loss.  But they have a powerful leverage to use against Netflix and they are using it.  Netflix still has to license contents from the cable companies, cable channels, movie studios or their subsidiaries.  As an example, Netflix has not been able to renew their deal with Starz and will lose Starz premium contents from their streaming service starting in Q1 2012.  Starz has a simple goal, they would be happy to license their contents to anybody (Netflix included) as long as they can keep the cable industry strong and allow the $90B to flow within the value chain.  It would be hard to do a deal unless Netflix sells a significant stake of the company to one of these cable companies.

There is another industry that also wants a piece of Netflix’s revenue, the internet service provider.  Netflix is distributing videos on their distribution networks for free (i.e.: cable and DSL networks require massive capital to build) .  They want a piece of Netflix’s service revenue.  Since they are not getting anything from Netflix because of FCC’s affinity for Net Neutrality, they are discussing new pricing model for broadband internet where consumers pay for the amount of bandwidth they use (as opposed to unlimited today).  The new pricing will increase the cost to stream Netflix video to the consumers.

Therefore Netflix’s recent struggle was not caused by the price changes or anything else.  The real fundamental problem is they are fighting a strong and intertwined value chain that has every reason for Netflix to fail.  This is a classic example of disruption theory at work where an entrant is trying to fit disruptive technology in an established market with powerful incumbents.  Netflix will not be able to afford premium contents going forward because the incumbents will do whatever they can to protect their business.

But Netflix will always have a niche – a powerful niche in my view.  They still have 20m+ subscriber and $2B plus to spend on contents.  They have control over their profitability on the minimum they need to spend to satisfy and grow their user base.  There will always be a subset of the consumers that want low cost video subscription service ala Netflix  ($8/month as opposed to $80/month cable bill).  They will be satisfied with the limited selection of documentaries, kids’ cartoon, teen dramas, foreign titles and be pleasantly surprised with a newer title from Dream Works once in a while.  Netflix will dominate this segment.

Tablets will also be favorable to Netflix as they are mainly media consumption devices.  A 10″ tablet device just does not feel right if you don’t have a video service such as Netflix.  Yes, Amazon has a competing service that they bundled with Amazon Prime.  But if you look at the movies and TV shows that are available at Amazon.com, you can tell that their catalog list is still mediocre because this is not their main business.  They want to hook people with their Prime membership and free 2-days shipping to generate even bigger sales for their $40B e-tail business.  The digital video subscription is just an additional marketing cost to lure people into Amazon prime.

Go to Best Buy today and look at all the new TVs and Bluray players that are displayed, *all* of them advertise the ability to stream Netflix.  This is a very large distribution channel that makes it easier for Netflix to gain new subscribers.  They still have a lot of room to gain more subscribers domestically and internationally.

It is my view that Netflix will continue to be successful as a business that caters to the low end of home entertainment market.  From hearing and reading about Reed Hastings, he just does not seem like a guy who will sell his company – unless maybe he lost control of the investors/boards.

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