Netflix’s Long-Term Business Model Flawed, Competitors Willing To Give Content Away

As much as Netflix says they aren't trying to create a subscription based content service that competes with cable, that's exactly what they are trying to do. The company is licensing exclusive content in an effort to try and retain customers and sign up new ones, but their long-term business model is flawed. Netflix thinks that having access to a series like Mad Men is enough to keep customers subscribed in perpetuity but the problem is that once a customer blows through the episodes and has nothing else to watch, they will cancel.

Netflix's CEO has compared their licensing of exclusive content to what HBO does, but that's a bad comparison. While cable channels like HBO have exclusive content, they also have fixed delivery time frames. This means that customers can only watch content when HBO wants them to, including modifying what content is available on-demand. When Netflix was the only service in the market to offer this kind of content, Netflix focused on the breadth of their library, not exclusivity. But with competitors like Amazon willing to give away the same content that Netflix is charging for, as a loss leader for their other products and services, Netflix is now scrambling by trying to get exclusive content to keep customers. The problem is that long-term, this approach by Netflix can't last because they have no way to compete against free.

Long-term, Netflix business model for licensing exclusive content won't work. When a competitor comes up with a way to deliver streaming content in breadth, think Amazon and Google, Netflix is done. Netflix can't afford to give the content away like Amazon, Microsoft, Sony and Google can and Netflix doesn't have any other products or services they can sell. In addition, when it comes to the digital delivery of video, the studios have complete control of the content, the MSO's own the last mile and Netflix's prior advantages in the physical world of DVDs completely disappears in the digital world. If Netflix doesn't own the content or delivery, then why would they have a superior service when others are willing to use movies and TV shows as a loss leader?

Some might argue that Netflix will just acquire a large library of content on an exclusive basis, but that won't happen. Studios make the most money by licensing the same content for many platforms, not just one. Netflix can never charge enough for their subscription service to make up for displaced DVD revenues and Netflix doesn't have enough money to license a large catalog of content on an exclusive basis when it is estimated that Mad Men alone is costing them $75-$100M for seven seasons. We all know that studios make their money by selling us the same content multiple times for different platforms. An on-demand offering for one low monthly price would kill the studios business model since consumers would not want to watch the content via other platforms if they knew it was already available on-demand any time they wanted. Netflix's model completely disrupts the studios window strategy for making money.

In addition, someone I was talking to about Netflix made a good point about the studios not wanting to be “iTuned” like the music industry was. The studios will try to encourage as many channels for content delivery even at the expense of short term profits to maintain longer term survivability. Having one company like Netflix control 80% of the streaming movie business, the way Apple owns 80% of the music market, is not in the best interest of the studios. For many years, Netflix's strategy was that no one else could have the breadth of content they have or be on as many platforms and devices. But that's no longer the case with Amazon and other competitors are starting to catch up very quickly. Now, Netflix is focusing their efforts on exclusive content, with the same strategy that Blockbuster had, thinking that content exclusivity would save them. In the long-run, it won't work.

Netflix is no longer the only game in town. With content subscription services from Hulu, Amazon and DISH, video on demand from the MSOs, services like Comcast XFINITY TV, and other competitors like Microsoft, Sony, Google and Redbox all entering the market soon, Netflix is going to get squeezed. This is the whole reason no MSO has bundled Netflix's service in with their cable TV offering, it's competition. I expect we'll see this happen for Netflix's service in Latin America, but that's more out of a necessity for Netflix since most consumers in Latin America don't have credit cards and Netflix will need to use the local MSO for billing purposes.

People always fall back to the argument that Netflix's content is better, but it comes down to what's "good enough" and what people are willing to pay for. Also, most seem to argue that Netflix is only $8 a month, but remember that Netflix is not a replacement for other services. So it's $8 a month of top of a $100 cable bill plus other services like Hulu Plus that a consumer might also be taking. And for a consumer that already has something like XFINITY TV and Hulu Plus or Amazon Prime, do they really need Netflix? You have to add up the value of all the services a consumer has and then compare it, as a whole, to Netflix's offering.

Netflix has the chicken and egg problem. To get subscribers, Netflix needs content. To get content, Netflix has to pay the studios which requires subscribers. Netflix is having to commit to up front massive payouts to studios for whatever content they can get. But if subscriber growth stagnates, Netflix could quickly find itself upside down in those agreements. From a financial perspective, Netflix has already estimated it won't be profitable next year as they expand into new territories in a clear sign that content costs are skyrocketing.

Long-term, Netflix is going to face some serious problems, some of which we are already starting to see. Netflix's continued need to increase their content library, and have exclusivity, has a lot of upfront costs that could increase monthly fees in the near-term and slow subscriber growth rates. And while Netflix content might be a bit better than the competition, competitors services will become good enough and make Netflix's cost of customer acquisition and churn increase. 2012 is going to be a very tough year for Netflix.

Updated: I've gotten a few emails from people saying that no one seemed to be making these arguments when Netflix's stock price was at $300 a share. Actually, many were. In September of last year, when Netflix stock price was at $165, I was making the very same arguments, as were others. So it's not about people all of a sudden piling on Netflix when the company is having trouble.

Disclaimer: I have never bought, sold or traded a single share of stock in any public company ever.

  • Connected Mark

    Dan- excellent post.
    As an insider in the space, I advise investment banks and hedge funds, and the end of last year when NFLX stock was rockin’ I told one fund, “They are absolutely headed for a brick wall, the wall will not move, I just don’t know when they’ll hit it…” I then spent the rest of my session doing some back of the napkin math with these guys to show them that based on the postage savings argument alone, their digital business model was flawed and something would absolutely have to change. We then discussed the reality of their licensing deals, and these smart Wall Street guys suddenly had light bulb moments.
    But I must say, I would not have predicted the dramatic stock price collapse we’ve seen. The reason I don’t believe their troubles are because investors and naysayers are “piling on” is because the market is so volatile that it would have been possible for them to experience a sharp drop, but as investors realize the underlying business model is still sound, run the price back to a normal range. But their stumbles shined a spot light on the gaping holes and flaws in their thinking which has driven the price to the actual level of the companies value, and not some artificially inflated range as we saw a few months ago.

  • Luis Decipo

    Dan, if Netflix was able to move from DVD to streaming, from broad catalog to exclusive content, they might have something in their strategic plan to keep evolving, and profitable. You made some good points, but imho your are underestimating them.
    Regarding your comment “most consumers in Latin America don’t have credit cards”, it’s true that credit card penetration is not as high as in North America. However, in Latam people who are subscribed to cable TV have a bank account (direct debit is the usual practice), and the vast majority of them are credit card holders.

  • Hi Luis, the latest figures I have seen, put out vby VISA, show that Latin America has a credit card penetration rate of 32%. So that’s not the “vast majority” as you suggest. VISA says that 70% own a debit card but they also mention that one of the main obstacles with debit cards is that they are limited for online purchases.

  • Great post, but overstated just a little? Netflix has the advantage of first to market and mass penetration, giving it a very large and loyal user base, and a well developed technology (recommendation engine) and that means market winner unless the company drinks poison or fails to remain competitive.
    They made the mistake of making a big change without adequate foresight at the wrong time for consumer economics and the competitive environment, and hurt themselves. But it is likely more of a learning lesson than a mortal wound.
    Netflix is likely to leverage their advantages, but now they will have to be very competitive. Their quest for new content, that consumers are hungry for, will likely help keep them on the competitive edge against AOL, Youtube, Hulu, and BlockBuster type Internet channels. The subscription channels are going to be very competitive.
    I don’t think these Internet channels will displace cable except for a few, and it will make cable get more competitive offerings. These channels are just another offering in a very changing market, and one of these days the competitors will eat each other until there are only 3 big ones.
    The public is very hungry for -new- good content. The biggest winners will be the content producers.

  • Dan,
    You write that “This is the whole reason no MSO has bundled Netflix’s service in with their cable TV offering, it’s competition”. This isn’t quite true.
    While this is still a loose partnership, MSOs are trying to come up with models to work with Netflix.
    Netflix may indeed run into problems, but at this point, no one else has their service ported onto as many platforms as Netflix. I have a Wii and looking to buy Roku sometime in the future. I also have an iPad. I cannot get anything other than Netflix on Wii for now. I will probably never get Amazon on my iPad. I am not going to buy the Fire just for that. I have a Hulu+ but I am going to cancel – not enough movies for me. Netflix has the best selection of movies, TV shows and documentaries and for $8 is a complete steal. The key is $8 – as long as they don’t change their price, I see no problems for Netflix.

  • Hi Ram, as of today, not a single MSO has bundled Netflix in with their TV offering. The link you provided is an MSO providing a search functionality across TV and OTT content, but as the article states, “separate subscriptions” to Netflix, Hulu Plus and Amazon are required. That’s not a bundled offering.
    The platforms/devices you call out that Netflix is available on have nothing to do with pay TV services. The Wii, Roku etc… are devices, they have no TV services.

  • Dan,
    I realize that Wii and Roku are devices – my point is that no other streaming service offers availability across the diverse multiple of devices. For example, AFAIK, Amazon is not available on any of these platforms. You have to buy the Kindle Fire to access Amazon content. I am not talking about laptops – I have stopped using laptops as media devices after the iPad and iPhone. So availability over Flash on laptops does not cut it any longer. You cannot watch any of the Google movies on iPads for instance.

  • Amazon is not on every device Netflix is, but it’s on hundreds of devices already. Amazon’s keeps a list of compatible devices at:
    The big missing devices for Amazon right now are the gaming consoles and iPad. But once Amazon starts offering more support for HTML5 video, then it will work on the iPad via the browser. Won’t be overnight and I agree that Netflix still has a device advatange today, but that won’t last forever. Amazon is really starting to catch up and it only a matter of time before they are supported on nearly all the same devices Netflix is on.

  • rose

    I think in the end Netflix is still going to fail. With them trying to do only streaming content they don’t have enough for someone to pay the amount they want. I had them before and their streaming services had horrible content. They were movies that were extremely old and I didn’t care for that. I have the Blockbuster Movie Pass through DISH Network for the very reason that I don’t want to wait 28 days to watch a new release and Netflix you had to. You also had to have the DVD service in order to get new releases. With the Pass on my employee account I pay only $10 a month and it includes streaming, mail-in DVDs, in-store exchanges, games and Blu-rays for no extra charge, and 20 premium movie channels. This is worth my money more then Netflix would be.

  • Ted Kerr

    For all your effort to knock the industry creator/leader, you havent quite explained why they’ve managed to add 7 million new subscribers in the last year (even after accounting for the price increase losses). I think you’ll continue to be confounded as they continue to add millions of new subscribers and return to profitability in late 2012.

  • @Ted: easy for Netflix to sign up subscribers over the past 18 months when they had very little competition. That’s quickly ending.

  • Dan,
    I completely agree that Netflix is facing heavy competition as other players enter the market with similar offers. However, I’d like to point out one huge competitive advantage for Netflix that has not been mentioned: it’s user experience.
    Netflix has a great UI and an amazing recommendation engine with it’s own quirky personality. Hulu has a strong UI but I never really find myself ‘discovering’ new things on it, and while Amazon offers unbeatable prices on digital content, their user experience is horrible.
    While I’m not on the Netflix bandwagon, I believe there is more to unseating this player than spending money on content deals.

  • Good information and well written as usual, however I disagree a bit.
    Instead of comparing Netflix to Google it might be better to compare it to iTunes. What Netflix has is its existing relationships with the Studios who su…pplied them with DVDs (movies) for that window of distribution. Now as of late, this has shifted over to online distribution, however, DVD at the retail level continues to be a major and dominate source of income for the Studios. Over half of a Studios revenue from a particular IP comes from the DVD market, surpassing even box office net. Online is coming on strong, but not there yet to match this level of revenue. May still take 2-5 years!
    Netflix was in preparation for the online shift. Perhaps they made some errors with coming up with a second service, branding issues, then reverting back again into one service.
    However, for them, in order to spring back, they would now have to license more movies for online distribution downloads. They have the relationships in place and the track record via their DVD performance and proven service. Goggle, with all their might, failed to license movies from the Studios which is one of the reasons why their Google TV didn’t take off as of yet – which could change on a dime.
    It is MOVIES available for download on all devices which is KEY now. Either those companies like Netflix (or Apple that has done so already) that can obtain the rights to license this compelling content which may propel them to become leaders in this space.
    The only other alternative is for any company, who can create their own movies that are on equal footing or caliber with the existing Studios. But that requires another skill set that most companies (except the existing Studios) don’t have.

  • bathswana

    Seems to me Amazon is the one with the problem. They are giving away content that costs them money.
    People who sign up for Prime just to use the streaming service (not to buy merchandise from Amazon) are in effect paying almost as much for Prime as a Netflix streaming subscription.
    And people who want a high quality video streaming service probably don’t want to sign up for Prime. Hell, many don’t even know the service exists. Everybody, on the other hand, knows what Netflix does.
    In addition, consumers who use the Amazon streaming service are probably not as likely to purchase or rent their a la carte video offerings, both of which they still offer (as well as selling discs).
    And Amazon has only 5000 streaming titles. Netflix has over 20,000. How long will it take for people to watch all the content that interests them, from what Amazon is offering?
    Seems to me Amazon is trying to be a lot of different services to a lot of different types of consumer, and instead are excelling at nothing. I’m not sure Amazon knows what they want to be in the video space.

  • I think that any competitor no matter who it is has to potential to beat/tie netflix. I agree that netflix has hit a brick wall and this will definatley cost them. Netflix did so well for so long because there was no compitition(or limited compitition)! Now with other companies coming to compete they talk of raising the price!? How dumb could they be! They lost countless customers because of stupid neglagence. The customer is always right, and if Netflix won’t give us what we want I’m sure some other company will be happy to.

  • Stuie

    The real winner for streaming movies will be the one that can offer the widest selection of movies while having good video quality, Good pricing, a good UI, and good recommendation engine. So far Netflix is doing very well in all of those areas. Until someone can come closer to offering all of that Netflix will continue to dominate based on its name recognition and its availability across the most popular devices. Only having a wide selection of movies won’t win many people over.

  • Adel Antado

    I agree with Stule’s comment: Netflix prices its content to make competition difficult, if not impossible. Netflix has become the Coke of the movie streaming business even in the environment where You -Tube and Hulu were free streaming competitors. The talk of competiton with Netflixs fades as quarter financials are made public.