By Dom Serafini
Lately, Netflix is the most-talked about new(ish) kid on the TV block, since over the years it has been a master of adapting and transforming itself. Netflix evolved from its initial DVD rental business (flat rate for mailed DVDs) in 1998, to a DVD subscription (monthly flat fee for unlimited mailed DVDs) in 1999, to video streaming in 2007.
Now it is changing its business model again, moving closer to a traditional TV delivery service. Netflix is in talks with U.S. cable TV companies to place its streaming app on set-top boxes, representing a rapprochement with the traditional TV sector. In Europe, Netflix already has similar deals with Virgin Media in the U.K. and Com Hem in Sweden.
For the near future, Netflix is also targeting theaters with day-and-date releasing, seeking deals to secure theatrical films in the $15-$30 million production range released simultaneously with cinemas, and keeping them online up to 45 days after their release, with a service similar to a VoD Premium (charging an added fee on top of its $8 subscription fee).
Reportedly, Netflix moved into theatrical day-and-date releasing because it hasn’t seen as much success with its films as with its original TV programming. This is despite its Cinematch, a system that makes recommendations about which movies customers are likely to enjoy.
Currently, theaters play movies at least 90 days before any other platform and they reportedly could be persuaded to reduce it to 45 days since 96 percent of a film’s box office is achieved in its first 42 days. However, there will be resistance from hotel-based VoD services (where new movies are shown 45 days after theaters), and services such as iTunes.
And all of these plans are taking place in the midst of a global expansion strategy that currently gives Netflix 40.4 million subscribers in 41 countries, of which 20 are in Latin America (Cuba excluded), a region Netflix entered in 2011. The growth in Latin America has been slower than expected, but given the expected improvement in payment systems and low pay-TV penetration, Latin America is expected to be an important market in the future. According to some analysts, if Netflix can achieve a penetration of five percent of Latin American HH over the course of the next six years, it can gain close to seven to eight million subscribers.
Although broadband penetration and speeds are still low, they will increase over the next few years. Payment issues have also hindered Netflix’s growth in the region, but the company is trying to simplify the payment system, possibly to include pre-paid credit cards for people who don’t own credit cards — the way Apple does with iTunes — and offer affordable prices.
In the Dominican Republic, for example, the fee for Netflix is considered a good deal, since renting a movie costs 150 Dominican pesos, while a month of Netflix is 300 Dp. It’s also a good price in Brazil, considering that a pirated DVD costs R$5, and Netflix is R$14.99 per month. Naturally, viewers have to add Internet charges to the monthly fee, which in Brazil is an additional R$60.00 for 10Mbps.
In the past, LATAM programming consisted of original-language shows with subtitles, as well as some dubbed when possible. Now however, Netflix is increasingly demanding dubbed programs from suppliers while it is renegotiating old contracts to include cable rights. To achieve this goal, industry observers cite the fact that the two top execs at Netflix LATAM, Jessica Rodriguez and Pablo Corona, both come from the cable network industry.
Several TV program distribution executives paint the picture that, up until recently, Netflix requested exclusive SVoD rights, in all languages, and most rights granted for LATAM were Internet streaming only (no permanent downloads). If a dubbed version was not available, Netflix would dub or subtitle it themselves. Plus, they covered digital delivery costs. Now, Netflix is trying to include more territories under one deal, extend their rights and, for LATAM, they are requiring Spanish and Portuguese dubbed versions. Moreover, files need to be digitized and sent, which adds more to the costs, thereby often rendering the deal a loss. Also, the monies they are offering are less than before. However, some content distributors reported that, at times, Netflix offers performance-based deals in addition to their traditional flat license fee.
But LATAM is not the only challenge for Netflix. Entering France, for example, is proving problematic due to the resistance of the powerful theatrical exhibitors that will not allow for the reduction of the SVoD window to go below 36 months. Plus, French laws require that SVoD services allocate 21 percent of their annual revenue toward investment in local and European films, and that they pay a sales tax of 19.9 percent. Similar problems are also found in Singapore.
Originally, Netflix’s DVD-by-mail business competed with Blockbuster and worked well because they were able to buy DVDs in retail stores, and copyright laws allowed them to rent those DVDs out. Netflix’s video streaming instead went head-to-head with giants such as Amazon, Hulu, iTunes and YouTube (which is now moving into subscription TV with its own 50 channels), but it succeeded because of its original programming strategy and scheduling, which allows subscribers to binge-watch entire series.
Now, by entering the cable and satellite delivery model, Netflix is getting closer to an HBO-like service, complete with original programming. Indeed, Netflix sees itself as the Internet counterpart to HBO, especially considering that HBO’s business model, which relies exclusively on cable and satellite subscribers, makes it difficult to offer its HBO Go Internet service to non-cable subscribers. “The network that we think is likely to be our biggest long-term competitor for content is HBO,” Netflix stated in its annual report.
In the U.S. Netflix has 31.2 million subs, compared to HBO’s 28.7 million. Netflix’s worth is estimated at $12 billion, the same as HBO if it were to be spun off from parent company, Time Warner.
To aid the Internet-cable transition, the U.S. Congress is considering a bill that would give online TV services like Netflix, Google’s YouTube and Hulu the same access to programs as cable and satellite get today.
Netflix’s business model has four main components. On the cost side, there are content, marketing, shipping and bandwidth and technology expenditures. In the revenue column, for now, there’s only subscription fees.
According to some accounts, because of programming costs, Netflix is spending itself into a corner. In particular, digital media analyst Michael Pachter calls Netflix’s model “unsustainable” (however in the past he overvalued Blockbuster, which recently went bust.)
Netflix now spends about $200 million annually on original programming, about 6.7 percent of the company’s $3 billion 2014 budget on program licensing. It has already committed to spending $5.4 billion on content deals, with $2.5 billion of that due during 2014. According to Pachter, Netflix’s original content and top-rated shows are merely licensed on an exclusive window. “They have the rights to show the stuff for two years and that’s it. [That’s] unlike HBO, which owns some of its original content,” he reported. However, one producer explained that, for their territories Netflix retains four-year exclusive rights on original programming (after that, the SVoD window on perpetuity) and that they do not fully pay for production costs, pointing out that, to get distribution rights, Sony Pictures put up $1.5 million for the MRC-produced House of Cards series ordered by Netflix and for which they spent $100 million on its two-season remake (26 episodes).
This is how Netflix explains it: “Our licensing is generally time-based, so that we might pay for a multi-year exclusive subscription video-on-demand (SVoD) license for a given title. Typically our bids are for exclusive access to the SVoD rights.” A U.S. studio executive added, “they’re smart and know what they’re doing.”
The fact remains that Netflix needs to spend money on content — licensed or original — to continue to grow its subscriber base, while keeping its cancellations (which can reach five percent a year) at bay.
According to some analysts, Netflix will reach peak penetration of 50 million U.S. HH and that same level internationally later on. This scenario is based on a total subscriber base of 140 million with 70 million in the U.S. and 70 million internationally.
For its part, Netflix CEO Reed Hastings stated that the company could reach 60 to 90 million subscribers over time, but struck a note of caution. “The larger we get, the harder it is to grow,” he said in a video webcast. Netflix faces competition from Amazon, Hulu and the newly announced Warner Bros. streaming venture with Facebook, as well as churn that makes it hard for subscription-oriented businesses to grow beyond a certain point.
In addition, to promote its services, this year Netflix will invest $500 million in marketing and over $400 million in streaming delivery, sign-up and billing technology developments.
Original programming is costly to produce and to stream, since dialogue has to sync with the video being shown at different Internet connection speeds — unnecessary steps when Netflix licenses library content, which often has the technical work already done. Netflix’s streaming service is accessible on any of the 800 compatible Internet-connected devices, accounting for viewers who have different Internet connection speeds, various screen sizes and different technologies running the devices.
Streaming also costs money. Watching Netflix requires ISPs (they mostly use Amazon’s AWS 10,000 servers) to move a lot of data and, according to some analysts, Netflix’s streaming service accounts for 28.8 to 33 percent of all U.S. primetime Internet traffic, dominating the online video business. YouTube follows with 18.7 percent.
Reportedly, Netflix pays about 2.5 U.S. cents to stream a film and/or a TV show. It is calculated that streaming on AWS costs about $0.05 per GB, which for Netflix represents $250 million per year. This compares to $600 million yearly, which was used for shipping DVDs in their peak years. While most video contracts with third-party Content Delivery Networks (or CDNs, a distribution system that accelerates the Internet delivery of audio and video files) are typically priced on a per-gigabyte-delivered model, Netflix (and other large content distributors) pay the CDNs (like Akamai Limelight and Level 3) on a per-megabyte-per-second-sustained model.
Netflix doesn’t pay for the total number of bytes it transfers each month, but rather the total amount of bandwidth it peaks at each month, a pricing model also referred to as 95/5. This means that customers can burst above their committed rate of megabytes-per-second less than five percent of the time with no penalty, but once they go over that, Netflix pays for overages.
A report in the Wall Street Journal claims that at this time, Comcast, AT&T, Time Warner and Verizon are not willing to give Netflix space in their datacenters, expressing concern that doing so for Netflix would allow other content providers, such as Amazon, to demand the same access. It should also be noted that some of those ISPs are also in the business of content providing, and improving the performance of Netflix is certainly not in their interest. Plus, they are considering caps, though Netflix doesn’t mind if the “amount of bandwidth consumed by our product can be adjusted down to reasonable caps.”
Canada — where Netflix has been operating since 2010 — imposes a bandwidth cap and Rogers Cable bases broadband fees on usage, so Netflix allows users to scale the quality of their connections to manage the caps. In addition, if cable companies want to raise their broadband profits, most likely the increase will come from the consumers who want faster speeds and not from Netflix. For its part, Netflix announced that 4K video stream would be available in 2014, with the lowest-end stream requiring 15 Mbps connections.
But it’s mainly the cost of content that is hurting the company’s profit growth. In 2012, for example, Netflix posted revenue of $3.61 billion but an operating income of just $50 million and a net income of $17 million. By comparison, industry estimates peg HBO’s revenue in excess of $4 billion in 2012 and its operating income at more than $1.6 billion.
This is acknowledged by Netflix in its annual report: “The one material difference worth noting is original content production is cash-intensive and that means for us that cash is front loaded relative to the P&L.” This is because, in order to permit binge-viewing of original series, all episodes need to be paid to the producer at once.
Even though Netflix has been good at adapting to the marketplace and technology, future challenges are expected to grow along with its business. The problems cover all aspects: leveling sub growth rate, escalating programming costs, stronger competition, streaming caps and increasing shipping costs for DVD delivery.