Don’t Write Netflix Off Just Yet
Fasten your seatbelts: Netflix and other streaming video players are headed for a bumpy ride.
Netflix’s latest financial numbers are in, and the company has taken yet another tumble. The Los Gatos, Calif.-based service failed to add enough subscribers to fuel growth this past third quarter, forcing it to cut its full-year subscriber forecast.
Sure, the company now counts 25 million subscribers. And it’s still generating massive revenues, $905 million, up from up from $822 million in the same quarter last year.
But simply put, in Wall Street’s view, the company isn’t growing as fast as it needs to sustain its pace and face future challenges. Netflix signed 1.16 million new U.S. streaming subscribers in the third quarter, according to its report when analysts predicted 1.43 million. As a result of the shortfall, financial analysts cut their estimates and ratings on the company, and Netflix’s stock price took a tumble.
Growing Pains
The tumble is a stark reversal of the former Wall Street darling’s position over a year ago. Back then, Netflix enjoyed unprecedented growth, fueled by skyrocketing revenues and a surge in subscribers.
But like in any good movie, eventually the mighty stumble. In Netflix’s case, its struggling to delete:minefield is its] transition from its DVD-by-mail rental service — which still accounts for 90 percent of its revenue — to streaming video. Even at its peak, Netflix knew that its DVD-by-mail business, with its substantial mailing and inventory costs, would have to give way to a digital content model, as it did with music.
Netflix started its transition early, offering an ancillary streaming video service to its subscribers that quickly became the major focus of its business. The company took advantage of the opportunity to scoop up large amounts of content for relatively little cost, since the movie and TV industries regarded streaming as minor league, taking a backseat to cable and broadcast rights. As a result, it build up a substantial library of movies at a time when the few competitors — Hulu and YouTube, generally — were focused on TV or other short-form content.
In this way, Netflix took advantage of a propitious moment: it got an early start in a market just starting to take hold, but before other key players — mainly Hollywood — realized how major it would be. It perfected its streaming technology, working closely with device makers of all stripes to make sure subscribers could get its content smoothly and seamlessly on phones, laptops and even gaming consoles. As a result, it built and then cemented what would become a sizeable lead, even as the list of competitors grew. The result was a golden streak of financial performance, up to the summer 2011.
But eventually, the market caught up with them. Significant rivals like Amazon Prime joined the field, backed by deep pockets and major distribution muscle. Hollywood wised up and began charging higher prices for licensing its content, and Netflix lost some high-profile deals, such as its Epix library of films, to competitors like Amazon Prime.
The company made some uncharacteristic missteps as well, alienating what had been a highly satisfied customer base when it tried to separate its DVD business from its streaming arm in the summer of 2011 and institute a price hike of up to 60 percent. Netflix rectified the mistake after a loud outcry from its subscribers, but it seemed to mark the beginning of a new, more troubled chapter for the company.
Netflix is still inking content deals, and it’s also beginning to push into the relatively untapped global market, with substantial expansions in the ripe Scandinavian market. However, these avenues of growth won’t come cheaply and will likely eat into Netflix’s cash reserves, guaranteeing it won’t be the shining star it once was for awhile.
Rocky Waters During a Major Sea Change
Some industry watchers, on the lookout for deeper-seated reasons why Netflix currently struggles, pinpoint its CEO, Reed Hastings, who began the company after racking up $40 in late fees on a Blockbuster rental of “Apollo 13.” The current book release “Netflixed,” by Gina Keatings, reveals Hastings as a temperamental, stubborn leader with a poor read of consumers, the likely architect behind the botched attempt to raise prices and separate its DVD and streaming businesses, not to mention the graceless apology to subscribers afterwards.
Keatings characterizes Hastings as a “data-driven” executive who never lets compassion get in the way of strategy, but also notes his vision and fortitude have steered the company well. And Netflix’s management surrounding Hastings — most notably its chief content office Ted Sarandos — has been in place since nearly the company’s beginnings, so its decline has less to do with any management troubles.
Instead, Netflix’s current bumpy ride is a mark of how fundamental dynamics in the streaming video industry are changing for everyone. And the fallout could change the face of digital entertainment for years to come.
Fat Cats Wise Up
One of the major changes to the market is simple: there are just more providers of the same service. The list of rivals has grown since Netflix’s wild ride, and many of these competitors are linked with major tech companies with deep pockets: Amazon’s Prime service, for instance, and even YouTube, with its connection to Google. Netflix now has to compete even more forcefully for consumers’ dollars against a flurry of services promising the same thing and nearly similar price points.
And it can’t underestimate the ruthlessness of its competition: Amazon, for example, has shown a willingness to lose money in the name of dominating a market with its Kindle devices, and will likely pay whatever it takes to build up the most attractive content library in the future.
Another major factor is that the supply of content to fuel all streaming services is going up in price. Simply put, a wised-up Hollywood — the maker of all these TV shows and movies we’re watching on Netflix, Amazon and other digital outlets — is fully aware of the digital direction we’re headed in and is charging a lot more.
But beyond prices, the movie and TV industry is exhibiting much less willingness to strike exclusive deals anymore. Netflix is no longer the only service in town, and the TV and movie industry is using that to its advantage. Epix, which owns the digital rights to movies from Paramount, Lionsgate and MGM, ended its exclusive agreement with Netflix, opting to go with Amazon instead.
“The decision to do Netflix exclusively was because they were really the only game in town at that point in time,” said Mark Greenberg, Epix CEO, to Hollywood industry publication The Wrap. “We live in a capitalistic society and are here to generate profit for our owners. We are doing that by trying to help reach a larger consumer base, hence the decision to go to Amazon.”
It’s not just Netflix that is losing out on prized exclusivity: News Corp, which owns content from Fox, NBC-Comcast and ABC-Disney, were mulling ending their exclusivity with Hulu, according to Variety, taking away its competitive advantage of exclusive rights to current TV shows.
More deep-pocketed rivals plus higher licensing costs is a Molotov cocktail to shake up any industry, and the result has forced Netflix and its rivals into a new dilemma: how to differentiate itself from the crowd and lessen its dependence on its high-priced Hollywood supplier.
Scrappy Alley Cats Adapt
Facing its dilemma of high costs on increasingly similar content, the emerging streaming video industry could take a page from cable and choose to compete on service and offerings, bundling themselves into packages that consumers subscribe to. In a market that’s becoming increasingly fragmented, there’s definitely room for some kind of offering that lets consumers subscribe and pay one fee for an array of channels and service.
Instead, however, most players are taking the path that cable heavyweights like HBO and Showtime took to compete against one another: beef up original offerings in efforts to brand and differentiate themselves.
Similarly, Netflix is embarking on a well-documented spree of original material. It’s already launched its first original series, “Lilyhammer,” and is set to roll out more exclusive, original content next year, such as a season of cult comedy classic “Arrested Development,” the Eli Roth-helmed horror series “Hemlock Grove,” and “Orange is the New Black,” a series from “Weeds” creator Kenji Johan.
Other rivals are embarking on original content as well: Hulu is ramping up its original shows, while YouTube, which remains free but ad-supported, is taking a niche approach, creating hundreds of original content channels devoted to interests like cooking, skateboarding, fashion and more.
How Netflix Will Remain a Player
Netflix is focusing now on expanding its market overseas as well as ramping up its content deals to placate restless customers who increasingly demand more current content. As a result, the company will likely begin deflating its cash reserves, narrowing margins of profitability as it continues to weather a market in transition to its next phase. The days of the diva of Wall Street are over, and the company must dig in, learn to play hardball at the negotiating table with Hollywood and outmaneuver rivals like Amazon in getting the best content for its dollars.
But its eyes are on a longer-term prize in the distance. It’s telling that the company regards HBO — and not Amazon, Hulu or other streaming providers — as its chief competitor. HBO, which offers its own streaming service HBO Go to cable subscribers, recently started its own Netflix-like service in northern Europe, bypassing cable companies there altogether to offer its shows directly to consumers.
Given Netflix’s recent push in the same territory, beginning last week, “this will be the first test of our relative strengths in stand-alone subscription video on demand,” said Hastings.
In fact, the company foresees a time when cable powerhouses like HBO and Showtime will eventually break loose and begin offering their own streaming services, free of expensive cable packages. “We think it will make strategic sense eventually for HBO to go direct-to-consumer in the U.S., and become more of a competitor to Netflix; so, that is our operating assumption,” said Hastings in the company’s financial statement.
In this light, moves to bolster its original content now and broaden its territory make sense, laying the groundwork to weather further tumult as entertainment becomes increasingly digital — and position itself prominently when the transition is complete. As the industry overall moves to a “TV everywhere” model — on demand on a variety of devices, free of time and location — the digitization is bound to loosen up old partnerships and structures that have long been in place between studios and broadcasters.
But it will be some time before Netflix’s future of free-floating, standalone streaming channels becomes a reality, especially in the complex, interlocking deals that characterize Hollywood, TV and cable. But recent tension and squabbling between cable providers and channels over streaming rights for apps — not to mention the willingness of providers like Dish to kick off channels like AMC from their rosters because of its streaming deals with Netflix — could indicate future breaking points in the industry that could loosen up decades-long agreements.
But Netflix knows it — like its rivals — will be forced to stand increasingly on the strength of its original content. In this light, Netflix’s current strongest competitor, Amazon, still has some ways to go, despite its Amazon Studios initiative. Amazon can shell out for all the TV and movies now, but in the end, the companies with the visionary content that people want to subscribe to will win out.
The Ace in Hand
If the endgame comes down to original content, then Netflix may have the ultimate trick up its sleeve: its large store of finely-grained data gathered on its audience. Since its inception, its streaming service has accumulated a wealth of data on exactly what its customers are watching, when they watch it and how they watch it.
And they’ve shown a canny ability to use this data as a secret to its success: its recommendations, of course, are a key in keeping its audience hooked. Seventy-five percent of users select movies based on the company’s recommendations, according to its senior data scientist Mohammad Sabah to the Hadoop Summit in June, and Netflix is constantly angling to make that number even higher.
It’s also using this data as it pushes into original content: its next drama series “House of Cards,” for example, Netflix looked at various algorithms to see how its members responded to Kevin Spacey and David Fincher movies. It also was able to calculate the decision to release its first original series Lilyhammer as one entire season, since it knew its viewers overwhelmingly binge-watch TV.
In the end, this store of data will keep Netflix — as well as its digitally-based rivals like Amazon — ahead, especially against an established Hollywood industry that still relies on Nielsen ratings and focus groups.
Hollywood overall has long been criticized for its poor read of its audience. Its declining box office audience numbers reflect not just high ticket prices and the ensuing threat of digital entertainment, but the simple fact that the industry isn’t making movies people want to see. “John Carter,” anyone?
Netflix’s huge store of data — gathered on 25 million subscribers, who amass 30 million plays, 4 million ratings, 3 million searches and at least 2 billion viewing hours per day — is only rivalled by Amazon and other digital competitors. Through insights gathered by this data, it’s able to read its audience much more closely and act on this information in terms of programming choices and decisions, not to mention improving customer experience.
And in the end, its finely tuned-read of its audience may prove to be Netflix’s biggest advantage over its named chief rival HBO, especially as other factors begin to even out. The question is whether Netflix can weather the storm until it gets to that point. But it was able to anticipate where the market was headed before, and will likely continue to do so again.
