Five years ago, the director of my digital business master’s degree told me: “if you want to beat your competitors, you have to position yourself as close as possible to the user”. Fast-forward to today’s topic and this statement is extremely relevant for analysing Netflix business model.
One can argue that the entertainment business is very competitive. To be sure, there are dozens of ways a consumer can satisfy the need to be entertained (i.e. not bored). Books, magazines, newspapers, TV, radio, theatre, cinema, etc.
That was ten years ago.
In the last few years, these forms of entertainment have evolved and jumped into the digital world. Ebooks, blogs, streaming. Web, apps and smartphones are capable of delivering any kind of entertainment to keep us from getting bored. All at our fingertips. Anywhere. Always on.
In this scenario, incumbents are dealing with a kind of business model, set of attributes and proposals that they don’t fully understand. Netflix business model is an existential threat to the traditional way of entertaining people.
And it is just getting started.
The Netflix Pivot
Netflix business began with the DVD subscription model. This may seem strange for those of us living outside the US, but this is how it started almost twenty years ago.
Ever since the introduction of the streaming business in 2007, the DVD segment started to decrease and fade in importance. But it has taken some time for that to happen. Five years ago, DVD’s raked in half of Netflix revenue. Today it is just a footnote. Still, almost 4.5 million people are subscribed to the DVD by mail service.
Despite this, DVD’s are still a very profitable business. Its gross margin is about 50% each quarter like clockwork.
In hindsight, Netflix pivot is one of the most successful ones in corporate history. It embraced a competing technology that was starting to take off, way before it went mainstream through piracy. The company used its cash cow (DVD’s) to fund the business that will most surely would disrupt it.
This is a textbook example of what a company should do when confronted with a potentially disruptive technology. Should we ignore it, ridicule it, fight it or join it?
Fortunately for Netflix, they chose the latter.
The Netflix Business Model: User Proximity
Like so many other tech companies, Netflix business model is not a very profitable one. Never has been. Despite generating more than $2,000M in revenue last quarter, a company first, its net income was only $40M or 1.9%.
This approach is similar to Amazon, Airbnb and Uber. All these companies use a revenue generating business model to fund further growth within existing or future markets. In the case of Netflix, this growth has been fuelled without sparing margins:
Netflix has been leveraging its technology in order to create an experience that can reach a user anywhere, anytime. This end user proximity differs greatly on what other traditional businesses have been doing. And it is also an existential threat to Apple revealing the strategic importance of Apple Music.
Think about TV. Prime time is one of the most coveted block for placing ads in traditional TV networks. These businesses have to nail a delicate balance of creating programmes that attract viewers. At the same time, they sell this attention to advertisers in the form of TV commercials.
This scheme placed TV networks between advertisers and viewers / potential buyers, as close as the technology at the time allowed them.
The day only has 24 hours and, by definition, a limited amount of prime time. TV networks were not only able to position themselves in the middle, but also manage the scarce resource that prime time is. As long as they were able to produce good enough programming that viewers would watch, they got to decide the price of reaching them.
But then, technology created a new way to reach viewers and Netflix business model took advantage of it.
Netflix has broken all the rules. It has twisted one of the traditional networks business mantra: prime time blocks don’t matter anymore. The company led by Reed Hastings started licensing films and TV shows early on. But recently it has funded and produced its own content.
When a traditional network releases a new TV show (and visual content is increasingly leaning towards serialisation), they do it one episode at a time. Watch today episode one, next week episode two. Same time, same network.
This restriction plays their own strengths and prime time monopoly.
But what Netflix does is totally the opposite. They don’t have a TV schedule. Shows and movies don’t air at a specific time. There are no blocks, no prime time. Why? Because when Netflix releases a TV show or a movie, it “dumps” all the content at the same time. This way, users can watch every episode, every movie at their convenience.
This is especially relevant for TV shows. Episodes are not released in a weekly basis. The whole season is released at the same time.
It all comes back to Netflix business model and its proximity to the user. There are no advertisers trying to reach a bunch of viewers and paying Netflix for access. No.
Users sign up to Netflix for access to content. And in exchange, Netflix receives a monthly subscription.
By becoming the gatekeeper of its users, Netflix is shifting the balance in the entertainment industry. Hours watched within its digital premises are hours not being spent in front of a TV network and its advertisers.
Reed Hastings revealed Netflix mission statement a while ago:
Becoming the best global entertainment distribution service. Licensing entertainment content around the world. Creating markets that are accessible to film makers. Helping content creators around the world to find a global audience.
Have you seen that? Not a word about ads.
Networks have approached the smartphone revolution with indifference, if not outright hostility. But advertisers have to spend their money somewhere in order to reach their customers. Where will they go? Facebook, Google, Snapchat, Instagram, Twitter et al.
Some Users Are More Equal Than Others
All animals are equal but some animals are more equal than others – George Orwell in his book Animal Farm.
Analysing Netflix business model reminded me constantly of one thing. Not all users are born equal. There is a clear divide between the value of a domestic user and an international one.
In January 2016, Netflix announced that it was live in 130 countries. In spite of the fact that China, Syria and North Korea were left out of this expansion, Russia and India were amongst the new territories.
But as anyone in the business would say, not all users are born equal. Some are more equal than others.
After nine years operating in the US, Netflix paid user base growth was starting to slow down. It’s obvious that after a while, your home market would mature. Netflix Business model needed to keep on growing if it wanted to change the world of entertainment. Thus, Netflix ambitious expansion plans:
Looks promising. But don’t be fooled by these numbers. Those brand new subscribers Netflix is getting outside the US? Not even profitable. Let us compare first Netflix domestic ARPU (the drop in this graph is due to a change in the user count method):
And then, the international ARPU of Netflix:
If you think about it, makes total sense. Entertainment is a need that is only satisfied when a person has its other needs covered. In other words, it doesn’t matter that Netflix business model has recently added the population of Russia or India to its potential user base. Most of them won’t subscribe for the foreseeable future. Same would have happened with mainland China, for that matter.
Entertainment is a luxury. And so is Netflix. Streaming, subscriptions and services are big industries in developed countries (one of the reasons for the acquisition of LinkedIn’s business model by Microsoft).
Analysts and investors are obsessed over user growth, and shiver when Netflix under-delivers on this metric. But they forget that growing a user base is not the only way to grow Netflix business model. You can also make your current user base spend more.
Besides the obvious viewing plans and multiplatform approach Netflix already has, maybe advertising is the next frontier. Product placement combined with ecommerce? Food for thought.