16 Dec 2019

Netflix's Napster Moment

Netflix has been the darling of technology investors for the past few years. Since early 2017, its overall subscriber base has increased by roughly 60%, as it more than doubled its subscriber base outside the US. And, in response, Netflix's stock price nearly tripled over this period. By now, the engine for its growth is well known, i.e. original scripted content exclusive to Netflix. Of course, as we can see in the chart above, this has also dramatically increased its cash burn. Netflix's stated strategy was to invest into original content to acquire users and then subsequently ease off these investments to reach cash flow break-even. But a lot has changed in the global video streaming landscape since this strategy was conceived.

US & Western Markets

Netflix's first pivot into online streaming was built on a model of aggregating licensed content from other production companies. Essentially, Netflix was a one-stop shop for consumers, promising entertainment free of cable and enabling "cord cutting". As Netflix pivoted to its original content strategy, it became more valuable to consumers in the short-term. After all, they had more content to watch. But competing with your partners always has longer-term consequences. And in Netflix's case, production companies decided they were better off pulling flagship content from Netflix and building their own streaming services. Now, content from Disney-owned 21st Century Fox will be moving to Hulu, other Disney content will be exclusive to Disney+, The Office will be exclusive to NBC Universal's Peacock, Friends will move to WarnerMedia's streaming service HBO content will be available on HBO Max, and so on. Of course, not all these streaming services will survive, but Disney+'s early success shows that content is king and not the streaming provider.

All of a sudden, Netflix finds itself in a world where must-watch content is fragmented across streaming services with individual subscriptions. Not that different from the pre-cord cutting world. The content economics are largely similar and all that has changed is that it is now delivered over the internet. In this world, does Netflix have the freedom to cut down on original content investments? The subscribers they have acquired have their own niche tastes. If they no longer get new content  they are interested in, they have enough options available from competitors.

Even if Netflix continues to invest in content, is that enough to keep subscribers around in this world? Users are unlikely to sign up AND stick to every streaming service that has a "must watch" show. A fan of Stranger Things, His Dark Materials and The Mandalorian is unlikely to pay for Netflix, HBO Max and Disney+ every month. A more likely outcome is that users "hop" between streaming subscriptions based on what they want to watch. There is already evidence of this, as HBO NOW subscriptions in the past few years experienced a dramatic peak during every new season of Game of Thrones. Subscriptions then dropped back down as soon as the season was complete. This pattern will dramatically increase user churn and, consequently, customer acquisition costs. Of course, the other eventuality is an increase in piracy, which will also hurt economics.

Emerging Markets

If the situation in Netflix's core markets is dire, couldn't Netflix replicate its playbook over the last few years in supposedly "untapped" emerging markets like India and Southeast Asia? Netflix has had a hard time growing in these markets precisely because they are not untapped. Local streaming providers like Hotstar in India and iflix in Southeast Asia already have access to a significant base of localized content to attract local subscribers. In addition, they are far cheaper than Netflix (a significant advantage in price conscious markets). For example, Netflix's current, device-agnostic base subscription in India is 2.5X pricier than market leader Hotstar. Netflix has been testing mobile-only plans and longer-term plans at lower prices to entice price conscious consumers. In addition, Netflix is increasing original content investments targeted at these markets. Of course, these price cuts merely attempt to bring Netflix to price parity with competitors. In addition, creating original content for markets like India is always challenging because of language fragmentation. And finally, increasing original content investments while also cutting prices in competitive markets isn't exactly a sustainable strategy.

The Napster Moment

All in all, Netflix is in a bind. In its core markets, content is increasingly being fragmented across streaming services which will limit options to reduce content investments. In addition, it is likely to result in higher subscriber churn and an increase an piracy. In emerging markets, it is facing an onslaught from cheaper competitors with large local content libraries.

The upside is that Netflix isn't the only company facing these challenges. The entire video streaming industry is on an unsustainable path. High content costs, subscriber churn and piracy will affect everyone in the industry. This, in turn, is likely to create the conditions necessary for a new industry structure. Take yourself back to the music industry in the early 2000s. Revenue losses caused by piracy, and Napster in particular, forced industry players to co-operate and created the conditions necessary for Apple to unbundle music albums via iTunes. Video streaming is on a very similar path (a combination of unbundling and re-aggregation onto a single platform). Of course, a change in structure this dramatic will necessitate a significant reduction in content investments across the industry. So we should enjoy the golden age of TV we are currently in... while it lasts.