Netflix, boom or bust?

Netflix is the biggest video on demand service in the world. It has more paying subscribers than the largest US pay TV providers;  28 million globally of which 24 million are in the US.  It has changed the way studios think about content distribution, and how consumers access content on connected devices.

But all is not rosy under the hood at Netflix… Their role in the value chain is to realise a margin between content supply/delivery and consumer purchase. But in doing so, Netflix is hostage to the commitment of their suppliers and there are now big questions over the long term cost dynamics that could undermine their retail model.

Under the hood

Netflix is essentially a retailer with a temporary licence to sell studio and broadcaster content to consumers via connected platforms. It’s economics mirror those of Walmart and Tesco, exploiting a margin opportunity between the costs of suppliers and ground rent versus the prompt collection of consumer payment.

Netflix’s economics are based around two major cost items. The first is the cost of gaining access to content, and the second is the cost of delivering that content to the consumer via CDNs and broadband networks. These costs are mutually exclusive, provided by very different players (content producers/studios and telcos) but there are strong arguments to suggest that both could cause problems for video on demand players like Netflix.

A quick analysis of Netflix’s last six quarters reveals some fascinating insight into the challenges facing the business. The chart below compares the annual growth in revenue against the growth in content and delivery costs. I then go on to illustrate the resultant impact on gross profit and operating profit.

The analysis is revealing – consistently over the past six quarters, Netflix’s cost base has grown faster than revenues, which has recently begun to hit their profit line. This seems odd for a business whose revenue had been growing at a rate of over 45% year-on-year.

So why are costs rising?

It’s no secret that Netflix has invested heavily in content. They have to – they are fundamentally a content retailer and to compete in the market they need to build a compelling library of premium titles. But these deals are expensive and require Netflix to compete against some very powerful pay TV incumbents, who have financial muscle and a strong awareness of what it might cost them if they were to lose their lucrative content packages.

Fortunately for Netflix, content owners today like to distribute through third party retail services because they complement otherwise traditional mechanisms and generate incremental revenue. While this remains the case, studios will be only too happy to offer their content to Netflix and Netflix will gladly oblige.

But there are two challenges lurking – the first is whether Netflix can keep up with the likes of pay TV who generate significantly more revenue to invest in content. Take Sky, who invested $3.7bn in content in 2012 (including movies and sport) for the UK market alone. Netflix’s ARPU of $125 per year falls significantly short of Sky’s $1,025 per year (based on FX rate of 1.6).

The second challenge would arise when services like Netflix become so widely adopted that discretionary syndication of content begins to cannibalise revenues, encouraging the content owner to limit the range of services it distributes, forcing up the price.

Discovery Channel is a good example of this. During his keynote speech at IBC 2012, Mark Hollinger (President & CEO, Discovery Networks International) explained that they had made a strategic decision to be “broadcast first” before distributing content to on demand services. Over 40% of Discovery’s revenue comes from pay TV subscriptions (PPS) so to avoid any risk of cannibalisation and to protect their relationships with pay TV operators, they made the decision only to syndicate to third party services where there are specific market dynamics that would prevent them from going direct (e.g. in China).

Of course, Discovery has done a library deal with Netflix in the US which has proved very successful, but only because it has not cannibalised linear viewing. As soon as distribution no longer becomes incremental, Netflix is likely to feel the pinch.

Challenges in the network

Content is not the area where Netflix is likely to feel pressure. Network delivery and CDN costs may also pose a problem.

Consistently over the last 5 years, CDN prices have tumbled as the volume of traffic and limited differentiation in service has forced the product to become commoditised. CDNs have become such a utility that it is not uncommon for broadcasters like the BBC to maintain more than one CDN relationship and switch traffic between them depending on demand, usage and performance.

This is all very well in a world where the majority of our video content experiences are delivered via broadcast, limiting the volume of traffic on broadband networks to catch up TV, archive and movie streaming/download services. But what happens if IPTV becomes a more viable means of accessing content, increasing the volume of broadband traffic significantly?

The answer is that nobody knows… I’ll quote you two analyst articles published only a couple of months apart taking polar opposite views on the future:

The first from Nagra argues that today, DTH platforms with under 1 million subscribers would find it cheaper to distribute via IPTV than via DTH. And as we move into the future, increased volume of traffic will drive down CDN prices further allowing much larger scale operators to do the same. Their forecast D-Day for Sky in the UK is 2021!

The second article comes from a piece of work recently published by IHS Screen Digest which argues that our networks can’t cope with a wholesale shift to IP delivery, and that CDN is already more expensive than DTH for platforms with more than 8,000 subscribers. The article opens by saying, “the cost of providing over-the-top television services would rise to uncompetitive levels once scaled to meet the demands of large viewing audiences”.

The truth is, no one knows what the future cost dynamics of CDN delivery hold, and it’s causing massive uncertainty for content players. Here’s my take on the issue:

The first question is whether our broadband networks will cope with the incremental traffic coming from increased viewing of content over IP? I’m talking here about peak traffic, i.e. the maximum demand load placed on the network at a specific time of day. It’s not as easy as adding up the incremental traffic – we have to scale our networks to cope with the maximum flow, not the total volume.

The next question is an economic one – if investment is needed to provide appropriate network scale, who will pay? Unlike the broadcasting model, telcos charge the end user (the consumer) for access and ultimately pass on capital expenditure through the retail price. But if consumers aren’t willing to pay more, the telcos will be forced to look back up the value chain to content providers, impacting CDN prices.

Initiatives such as Youview in the UK (which is offered by BT and TalkTalk in the UK bundled with a broadband package) might provide an opportunity for telcos to squeeze additional subscription revenue from consumers that could be channelled towards network investment. In the short term, the vast majority of this incremental fee will go towards subsidising a set top box, but once the box is paid off telcos will still benefit from a monthly ARPU increase.

The challenge for retail VOD services like Netflix is that they have very little control over their CDN cost. If the networks pass on the cost of investment, Netflix will suffer.

Netflix facing a margin squeeze

It’s a difficult position for Netflix – they’re in a fantastic position to establish themselves globally as the default retail provider of content services to connected devices. But they’re facing a margin squeeze from both their content suppliers and CDN carriers. In the traditional broadcast world, those players who succeeded with made the investment to own and control their own distribution (e.g. Sky), or invested in their own originations (e.g. Discovery). Could Netflix do either of these? Perhaps this is why Netflix is commissioning its own content…

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2 thoughts on “Netflix, boom or bust?

  1. This is a great insight into Netflix and highlights so many interlinking issues faced by ISP’s, governments and Content distributors. I know from my own experience that platforms such as ITV player really struggle despite you ISP. I run a 13mb/s download, 1.8mb/s upload connection through an uncontended network and still suffer buffering.
    It will be very interesting to watch how companies like Netflix adapt to this harsh environment and whether ISP’s will take more control of this space like Talk Talk are trying to. What we see now is the blurring of traditional roles, can you be a residential ISP with out having a content option? Or are these ISPs losing a grip on their core competences and trying to be to over deliver?

    I look forward to the next installment.

  2. It seems like the entire entertainment industry is having an issue with the cost of providing content.

    Even though Spotify raised $250 million in funding last week (which takes their total funding up to $538m), they’re still experiencing massive looses due to the cost of content and struggling to find a long-term sustainable and profitable model.

    The entertainment industry needs to be disrupted, the only question is, who will be doing it. For now we’ll just have to wait and watch

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