Netflix has found itself being touted as the best streaming video service in the US, taken up by the average consumer for two clear reasons ‘ it’s available on a lot of platforms, platforms which can get the signal to a TV, and the name is now extremely well known.
But simply having a few partners and a strong brand may not help the company survive long term and we have to look at the economics of large video distribution to see if Netflix is a one trick Pony, about to embark on a fatal product transition or if it has the opportunity to take a stranglehold on movie, and perhaps TV series, online distribution in America and potentially the world.
The first thing to clarify is the way in which Netflix is acquiring customers and what that’s done to its margin and cost base, both in the past and recently and how streaming may help that in the future.
Back in 2004/5 Netflix was still growing and was a marginal concern, sometimes yielding a profit, some quarters not, and when it did it was a tiny percentage of revenue. There was a good reason for this. It needed to continue to buy DVDs at an incredible rate. But it saw off several 100 start ups which wished to copy its business model by one simple expedient ‘ when customers queued up DVDs that they wanted to watch, Netflix tried its hardest to give them the next choice in their wishlist. Other players in the US, and around the world, tend to pick and choose which DVD you get next ‘ making the service unpredictable and a little less satisfying, which is why their churn has tended to be higher.
But more recently, although Netflix has to continue to buy thousands more copies of each DVD release in order to satisfy the quality of service it has come to stand for, it has found ways to relieve this relentless pressure to buy DVDs. For a start, it now holds so many classic film copies that it can source all customer requirements on older films from stock, and even finds that it has a surplus of disks and has begun systematically selling off those which are no longer needed. It picked up $2 million last quarter in selling disks, which were surplus to requirements.
If we look at its latest published results for July, we see that the costs of supplying subscriptions has gone down as a percentage of revenue. If we compare that with previous Q2 results we see that the $315 million total subscription costs for Q2 2010 is a rise of 17% in costs, and yet there is a 41.5% rise in subscribers during that period, against a year ago. This means that the variable costs per subscriber has fallen to $21 a quarter from $25.4 a year ago and $29.4 back in 2007, so costs per sub ARE falling.
Cost of subscription per subscriber
Q2 2010 Q2 2009 Q2 2008 Q2 2007
$315 million $269 million $230 million $197 million
15 million subs 10.6 million 8.4 million 6.7 million
$21 per sub $25.4 $27.4 $29.4
It is also worth noting that the rate at which customers are taking up the service has gone up, almost directly ascribable to the new $8.99 rate, which allows for one DVD at a time, but unlimited access to the online service.
Percentage growth rate in customers from previous year
Q2 2010 Q2 2009 Q2 2008
41.5% 26.2% 25.4%
That difference between 41.5% and 26.2% is 15.3%, around 1.275% each month in customer acquisition improvement over a whole year. Now we might put hat down to churn reduction, brought about by the Free online service, but that was closer to 0.5% each month as churn has fallen from 4.5% per month to 4%. So something else is taking place here, and we suspect it is mostly improved consumer brand awareness.
The cost associated with subscription revenues consists of content delivery costs, such as shipping DVDs and streaming, as well as expenses related to the acquisition and licensing of content. It includes the packaging and label costs for the mailers and all costs associated with streaming content over the Internet. Costs related to free-trial periods are allocated to marketing expenses, but since the Subscriber Acquisition Costs have only gone up by under $0.5 to $24.37 from $23.88 a year ago, this is a small increase in overall costs, swimming against the tide of falling costs per subscriber.
Netflix breaks out fulfillment expense incurred in content processing including operating and staffing shipping centers and ingesting, encoding, inspecting and warehousing the content library, and these are all included in its overall cost of revenues. Subscription costs were $265.4 million for the quarter while fulfillment was $49.6 million, bringing total sub costs to $315 million, against revenues of $520 million. This, in effect is the Netflix gross margin and it needs Technology, R&D, Marketing and G&A off that to bring us to an operating margin.
But the trend is there for all to see in its numbers ‘ More customers come, but less DVDs per customer are consumed ‘ and the result is better margins and this is a long term trend.
Netflix tries not to give out details of its delivery costs, either postage or streaming, but the difference is now considerable. Volume rates for CDNs are well known and Netflix at its best is delivering video over the internet usually at 2 Mbps or 3.2 Mbps depending on the quality ‘ SD or HD. We reckon that 90 minutes of SD film will need 1.35 GB of payload and HD 2.1GB. This will cost around $0.03 per GB on the major CDNs which brings us to a cost of around 4 cents for an SD film and 6.5 cents for HD. These are streams which are in good enough condition to play on a TV set. PC streams are a lot lower.
Netflix Streaming Technology
There really is nothing new in the Netflix technology, this stuff is standard. Originally Netflix used Windows Media files with Windows Media DRM, purely because CE partners like Roku, LG Electronics, Samsung, TiVo and Microsoft Xbox found that easier to deal with. It uses variable bit rate adaptive encoding and targets a stream rate around 40% below the maximum capability of the end to end stream, so it won’t have to make many adjustments during the stream. This is sensible for film delivery.
Later Neflix updated its encoding with a new Silverlight player which uses Microsoft’s VC1 Advanced Profile with the newer PlayReady DRM. It’s done a few fancy things with the packet headers to ensure a smooth adjustment between different screen sizes, but more or less this technology is off the shelf and any rival could adopt it.
It has begun shipping streams that max out at 1.5 Mbps, with HD in 720p at either 2.6 Mbps or 3.8 Mbps (which we have averaged out at 3.2 Mbps). These all deliver 24 or 30 frames per second interlaced for TV and not interlaced for PCs. The quality on say a Blu-ray player will be a cut above this, but slowly broadband lines are heading to the point where full 1080p in 60 frames per second will be embraced by Netflix.
Netflix boasts that lots of its customers have streamed video and says that some 61% of subscribers have ‘instantly watched’ at least 15 minutes of streaming content during the quarter. It’s a pretty meaningless number but if we work on that minimum, it shows that there has been a huge effect both in terms of how rapidly it signs customers and how its churn and costs are falling, due to relatively few online streams.
On average it ships around 2 million DVD disks daily in the US. In video minutes that’s 2 million, times around one and a half hours each (roughly) shipped, so around 3 million hours per day, or 90 million hours a month or 5.4 billion minutes a month.
Online by comparison is tiny. The least it could be is 15 minutes each for 61% of its 15 million customers per quarter, so roughly 9 million customers times 15 minutes, say 135 million minutes per quarter or 45 million minutes streamed a month. About 0.8% of the video minutes it delivers. There is such a long way to go here and already that ‘at least’ 15 minutes of streamed video may be far higher on average, though Netflix doesn’t yet give this out.
But the effect has been dramatic, because in the public eye Netflix is THE online movie provider right now. When customers are really happy watching online and actually prefer it, these minutes will rise dramatically. Right now Netflix sees this as augmenting its DVD revenue ‘ in a few years it will replace it.
The viewers right now are early adopters, and we need to see a refresh in devices. Once you have a Roku player or a Wii or a Blu-ray player that plays Netflix streamed movies and will (in many cases) play them on your TV set, then this will rise to become a significant proportion of its $2 billion a year revenues.
Netflix doesn’t give out its postage costs, but it is spending between $0.75 and $1 per packet delivered ‘ we worked this out from its stated increases in postage costs and the increase in the number of packets it reports that it delivers. The difference in the two numbers depends on which quarter you take or if you take the whole year of 2009 or 2010 so far. This means that every time it streams a delivery instead of posting it, it saves at least $0.70, but its revenue stays constant.
Put this another way ‘ if Netflix shifted to 100% online tomorrow, it would add around $420 million annually to its cash flow from postal savings, or $28 per customer.
Which is why right now its costs have been rising, but nowhere near in step with its revenues. While revenues have jumped 41% its DVD postage costs have gone up more like 9%. This is because the number of DVDs being delivered is being offset by online delivery. So more customers sign up, but they each take less DVDs per month, because they use the online service as well. We suspect there is another ingredient here. When there is no online service, people want more DVDs in the house, so upgrade and call down more films, so that they have a choice once they decide to watch a film. By knowing that they can make that choice at the TV set, the number of postal packets will fall, and some Netflix customers will downgrade service. But the drop in costs will more than outweigh the drop in subscription revenues due to downgrades, and anyway, Netflix is currently finding it easy to sign new customers.
If each 4 DVD customer (allowed to keep 4 DVDs at once) takes around one online film each week, so 4 each month, but takes 1 of these online, that’s 25% of postage costs disappearing. That’s $0.70 each time there is a stream. OK we may have previously expected that streams would be additional to DVDs, but evidence in the Netflix figures says that this is not the case.
Which is why Netflix has suddenly, once again, become aggressive about moving overseas. It had said it would launch in Canada and in Europe back in the middle of the decade, but failed to show up. The idea of online DVD rental preceded it and Netflix-alikes sprang up in all these territories, gaining the early local branding initiative. LoveFilm plays that role in the UK, but has also branched out into other parts of Europe, and Glowria has done this in France. It may have cost Netflix too much to take its original model overseas, but it only has to go to the trouble of licensing the films in new territories (not to be under-estimated) in order to launch there with an online only service.
Neflix has shown its arm over the last few weeks, trying out an online only service in Canada. This is will be priced at a single $1 below its US introductory DVD offer of $8.99, at $7.99 a month.
Reed Hastings on the company blog site said this week that he plans to bring the same type of service into the US, one that does not include any DVD-by-mail option. The $1 lower monthly revenue will be accompanied by at least a $2.80 savings in postal costs, making any one subscriber in these territories more profitable than the low end existing online DVD rental customers in the US. So overseas launches are now cheap and will come at a rate, giving Netflix a broader revenue base to fight off any renewed US rivalry.
So unchallenged Netflix will become a global monster, in much the same way as its predecessor Blockbuster did all those years ago, but without the incumbent cost base of leased premises and DVD storage.
Naturally there are many types of companies who will cast an envious eye at the rapidly improving margins at Netflix in the coming quarters, and decide to challenge it. So who should we expect to come into the market against it?
Well the list is long, except that the only ones that will have a chance are those who can deliver the two things that Netflix can deliver ‘ an existing base of at least 15 million customer homes, and a service that appears to be additional to an exiting paid service, in that it is free.
That narrows it down somewhat. We might compile an initial list of pay TV operators, TV makers, broadcasters, handset App stores (Apple and Google), major internet services (Google, Hulu, AOL, Yahoo! and MSN) major retailers, Amazon, gaming console owners, and the studios themselves.
Indeed there is a move this week from Sony, Warner Brothers and Disney to offer films which are net yet in the DVD window through major VoD operators, with films costing around $30 a time. This is really a reaction to falling Cinema and DVD revenues and an attempt to create a new exploitation window for films. DVD film revenue has fallen to about 85% of its height, which was around 2004, and Cinema has fallen over a prolonged period to about 35% to 40% of total film revenue, having once been the dominant majority of film revenue. DVD rental is the same window, more or less as DVD sales (it is now delayed a few weeks to give the studios a big hit on DVD sales). Rental DVDs sell for about three times the price of a normal consumer DVD, so this is a significant revenue injection itself these days, but it comes from fewer and fewer players.
But introducing a new exploitation window for films is really about filling in the falling Cinema numbers. Everyone in the industry will tell you the opposite, that Cinema revenue is getting more and more each month. But this is the combined effect of a very complex equation. More films are being released, and go international very early on. The major films reach up to 4,000 cinemas in the first weekend in the US, in order to protect themselves from piracy revenue falls. Once this would have been closer to 1,600.
More Cinema screens are being built in countries like China, Malaysia and India, so there are more seats to hit, but then indigenous film industries are emerging to dilute this effect for Hollywood. At the same time the number of seats filled per sitting is falling in the US and Western Europe. This reverse has been temporarily halted by 3D cinemas. So big films get big cinema revenues earlier, but their overall lifetime revenue is likely to be down.
In the long run the best partner for studios would be an online service, not the walled garden of Pay TV VoD services. The Internet has long been the best way to tell the world about a new film, and the industry is terrified that if it uses the internet for primary delivery as well, it risks that 35% to 40% of revenue that it has in Cinemas. On the other hand, web based services will charge a lot less to play films than Cinemas, and they don’t have the same expensive concessions that see them taking half the ticket price and the same amount again in drink and popcorn.
So this new VoD initiative will either come to nothing or it is the start of moving the model to the internet, and that will mean going through Netflix type businesses at an earlier stage in the film’s revenue chain.
One of the things that the studios have to be careful of is that they do not offer one outlet a better price than everyone else. This will be seen as manipulating the market unfairly and lead to anti-trust concerns.
The $30 price for a movie that has just finished its theatrical run in the US is actually very low. We see the creation of rights lockers as likely to create a seachange in the market, systems such as DECE, which protect films and when you have bought them, keep them in a variety of formats, for TV, PC, Tablet and phone, in perpetuity. At $50 you might buy permanent rights to a film, or have a cumulative payment scheme, pay $30 to see it early and then add $20 at a later stage for ownership of a copy in all formats. This is the eventual business model of movies, with a residual 3D cinema chunk of revenue up front. But this is for a world which is post Blu-ray, in perhaps another decade.
But right now that $30 Pay per view price tag will not endear pay TV operators ‘en masse’ to the film going public and anyway walled garden VoD penetration in the US is only around 50% of pay TV homes.
But to be truly effective against Netflix and its ilk, the pay TV industry really has to take it TV Everywhere concept and run with it in the film arena. Now how might this work? Films might be made be free online for the 93 million pay TV homes in the US, but only the films that have already been licensed by the Pay TV networks, which at any point in time is a pitifully low number. And we must remember that right now Netflix offers monthly deals which can be cancelled at a month’s notice ‘ we don’t think cable can do that, and its typical 2 year commitment contracts will and do scare people away.
This might also require further license payments to studios for these films, because right now payments are mostly based on pay per view or on how many people take a particular film channel. It will also require the cable operators paying for delivery of films over the internet, as well as keeping their own infrastructure healthy with constant investment, at a time when US homes begin cord cutting, a phenomena that became real for the first time last quarter when Pay TV numbers in the US fell for the first time. The pay TV community will also have to avoid scrutiny as a dominant force, and yet will still only attack the part of the market they already own ‘ their customers – and will have to get all of the benefits of such a service from churn reduction. To us it looks like too big a risk and offers too small a collection of films to threaten Netflix.
Companies that make TV sets, such as Sony and Samsung, would love to have their own film services, but one of the fastest ways to achieve that is to sign deals partnering with Netflix, and the more they sign such deals, the more it makes it difficult to truly compete with Netflix with a sufficiently broad offering of their own, such as Sony’s Qriocity. They need to keep track of their main criteria, selling TV sets, first and foremost and much the same goes for most of the major bricks and mortar retailers in the US ‘ why can’t they gain from selling Netflix devices, rather than go into business against Netflix.
Amazon probably has the most vested interests of all the players to go up against Netflix and twice it has tried to enter the online DVD rental business and then dropped it as not profitable enough. Along with Wal-mart Amazon ships more DVDs than anyone else, so it needs to try to protect that revenue. Eventually, when a hybrid video/e-Ink screen comes into play in a year or so, Amazon might have a few tens of millions of captive devices in Kindles which become video capable, but for now it has no captive audience which it might offer a free film service to. It can offer a paid service and does so through Unbox video, as does Hulu with Hulu plus, but the uptake in these services has yet to be established. Right now there is no ‘free’ service offering that either can do to ramp up numbers at the rate that Netflix has. This is simply because of that huge incentive Netlix has, to ship the same films to the same people for the same payment ‘ but at a fraction of the cost.
Apple itself is married to paid content, and iTunes TV was supposed to have been born this year as a cable-like subscription service, but instead came out as $1 per TV series, pay per view offering. The content world is now suspicious of Apple’s strength and doesn’t want to give it any tools that it doesn’t give the rest of the market. That doesn’t mean that the studios themselves or studio groupings or films services like Starz cannot leverage off the App Stores and provide films to portable device apps, both in the Apple App store and Android Market, but the route to the TV is not yet established here and we all know that uptake is more rapid when a service can deliver direct to a TV.
The games console owners Microsoft, Sony and Nintendo are the final hurdle which might have put up stern resistance to Netflix, but not with a free offer, and anyway they will sit any efforts they have alongside Netflix, which is enabled on all three consoles.
The truth is that the cost of entry into this market is prohibitive, because someone has to swallow the content costs, and produce a partly or mostly free service ‘ and in order to license enough content to make a serious stab at competing with Netflix, that cost will run to around $1 billion a year today (the annual Netflix cost of subscriptions) in order to reach a similar number of homes to Netflix, and substantially more tomorrow.
The big indicator will be anyone who has the guts and presence of mind to enter the bidding to buy Blockbuster. So far it has filed for Chapter XI, but it has more or less all the same licensing deals that Netflix has, and it has a technology partnership with Sonic for the delivery of its service. The same can be said of Sonic with its RoxioNow service. But Sonic doesn’t sit in 15 million homes with existing monthly paid subs, so it cannot subsidize a free service with existing revenues, whereas Blockbuster might just be able to with the right new owner.
We know that Blockbuster is not actually for sale, but anyone that can see how pivotal it could potentially become, with the right strategy behind it, might make the bankruptcy court an offer it would be foolhardy to refuse.
There will be rivals to Netflix, but the worry is that those who have a vested in competing with it, are not seeing it right now as a big threat. Another year of acquiring customers and it may soon have as many as Comcast, the US’s biggest Pay TV operator and at that point, it is getting close to being too late. So even if someone emerges this year, either by buying out Blockbuster or licensing enough content and launching an $8 a month online service, subsidized down to free for existing customers, they will at best split the market with Netflix.
Where is the mechanism whereby Apple or Google blows Netflix out of the water with an irresistible service? It might be out there, but it needs to come out in the next 12 months and this season’s service and device launches are already cast in stone.
In the meantime what else can we expect from Netflix? It will continue to focus on raising the price of entry to this market by cutting revenue sharing agreements with studios and distributors, by securing exclusive content, by pushing content deals on a ‘per view’ basis across bother DVD and online. We know that it already has some joint deal with an up front payment and then a pay per view period followed by an option to buy permanent usage rights after a year or so. That will slowly mount up until Netflix has as much in the way of content rights as a broadcaster.
Where will this all end? Is there a market saturation in sight? Well the truth is no. Market saturation for Netflix is perhaps guided by the pay TV industry, at around 84% of US homes, so why should there not be 84% of US homes with an online film service one day.
We are taking that as 93 million US homes (around 68 million cable, 31 million DTH and 5 million IPTV ‘ with some overlap). Today Netflix has only made a tiny 16% of the market so far and even if it does take just 50% of the available market it may well find itself with 3 times as many customers in 3 to 4 years.
And why will it stop there. Netflix will slowly accrue TV series so that it can go up against Hulu (although it might choose instead to partner with it) with paid online TV. Just this week Netflix and NBC Universal announced a deal to steam all the TV series from the previous season on its online service. If it does a few more similar deals, it will have an across the board online service, not just a movie service.
Our assessment is that while everyone else bemoans the slow fall of the DVD, and the rise of online video services, Netflix will quietly steal a position of dominance, with a healthier and healthier profit margin, before the industry realizes that it has supported too few potential rivals.