Netflix: a house of cards or the new HBO?

In arguably the TV event of 2013 so far, House of Cards – a $100 million, 13-episode TV series starring Kevin Spacey, directed by David Fincher, and commissioned by Netflix, premiered exclusively online available only to Netflix subscribers in North and South America and in Scandinavia.

Metacritic, a site that aggregates critics’ reviews, reported that it received generally favourable reviews. It was also popular with viewers, and quickly became Netflix’s most-streamed program ever.

This is good news for Netflix. Over the past 18 months the company had been in dire straits, during which time it received a lot of press for its bold international expansion as well as its financial difficulties. Some observers postulate that it could become the next HBO, while others doubt that it will even survive the next five years.

So what is going on? How can a company that could be teetering on the brink spend $100 million commissioning a TV series, let alone push ahead with global expansion? Is Netflix’s business model sustainable? And if it is, what does its entry into original programming mean for the future of television?

Netflix built its brand with a compelling proposition as a virtual video store, where customers had 24/7 access to order DVDs online and rentals were shipped to subscribers via the US postal service with a postage-paid return envelop and no late fees, for a monthly subscription of $7.99. Netflix won customers away from the major video chains at the top end of the mass market; Redbox DVD kiosks focused on attracting cost-conscious customers; bricks-and-mortar behemoths like Blockbuster slid into oblivion.

In order to prepare customers for an eventual transition from physical disc rentals to streaming video rentals, Netflix introduced its “Watch Instantly” streaming service for about 10,000 titles from a much larger library, as a free value-add within the monthly subscription price in 2006. In doing so, it became the first mover of any scale in this emerging space.

The streaming video on demand (VoD) market for movie and TV shows only really took off in 2011, as Netflix was joined by Hulu Plus and Amazon’s streaming service for its Prime customers and annual revenue for SVoD (subscription VoD) in the US market online grew exponentially from only $4.3 million in 2010 to $454 million in 2011 +10,000%.

Total revenue for the online movie market (including SVoD, rentals and sell-through) tripled from $389 million in 2010 to $963 million in 2011.

Netflix had consistently met its financial targets and its share price rocketed to peak at $291 after it announced plans to expand into 43 Latin American countries following its previously successful international expansion into Canada.

Then it made an almost catastrophic mistake when it attempted to drive subscribers towards a faster transition away from physical DVDs to streaming. Netflix announced that it was splitting the two services, rebranding the DVD-only rental business as Qwikster with a monthly sub of $7.99 for DVD rentals only, and hiking the monthly subscription price more than 60% to $15.98 if customers wanted to have both DVD rentals plus streaming. Or, for $7.99, customers could continue to subscribe to the streaming-only Netflix Instant service.

The customer backlash was immediate and severe. DVD subscription churn increased significantly as angry customers departed in droves — one million per quarter. Netflix’s share price nosedived from its record high of $291.23 bottoming out at $52.81 per share in mid-2012.

Netflix quickly backtracked, abandoning the price increase, dumping new DVD rental service Qwikster and apologizing to customers. But the damage was done; a PR disaster ensued. The brand suffered badly and so did earnings.

Let’s dig a little deeper.

In December 2012, Moody’s downgraded Netflix ratings on two out of three scales – the CFR and Probability of Defaulting.

The rationale for Moody’s downgrade was that Netflix faced significantly higher risks transitioning from a high contribution margin DVD business to a lower margin, fixed-cost streaming service that would require a much higher level of subscribers to break even, in a market with low barriers to entry and intensifying competition some who might have differing motivations for entering this market, deeper pockets and might be prepared to undercut Netflix in order to take market share.

It also expressed concern about the damaging loss of many DVD customers following the Qwikster debacle, and speculated that streaming customers are likely to be “less sticky” than Netflix traditional DVD base, so it anticipated greater subscriber churn. This in turn would require Netflix to ensure a superior product offering to competitors and to deepen engagement with customers to attract sufficient volume of new subscribers and reduce churn to maintain market leadership and restore past levels of profitability.

Moody’s did, however, acknowledge that Netflix certainly had potential to increase its subscriber base and co-exist with rivals in a US market comprising 80 million US broadband households. Forbes magazine speculated that there could be up to 120 million broadband households in the US by 2019.

What options does Netflix have?

Raise prices

Following the angry customer backlash triggered by a hike in fees, Netflix has little choice currently than to stick to the $7.99 price-point. Management have taken a price hike off the table in the medium term. It is significant too that Hulu initially launched at $9.99, but was forced to reduce to $7.99 after it failed to gain any traction.

Increase the subscriber base

Netflix is the leading premium content streaming service in the American markets, way ahead of its domestic rivals. It currently also has the largest global footprint as Amazon operates only in the US and Europe (LoveFilm) and Hulu is only in US and Japan. No other direct competitor has truly global reach yet and a factor preventing truly global reach are territorial licensing restrictions that remain part of legacy contracts for existing release windows, but they impact Netflix, Hulu et al equally.

At the end of 2012, Netflix had 25.5 million in the US market and 33 million subscribers globally. Hulu Plus only had 3 million subscribers. Amazon does not release such data.

Concerns about Netflix being a company in transition are legitimate. DVD offered higher margins because once the cost of acquisition, warehousing, fulfilment, and postage were recouped, each video rental’s net was profit – split on a revenue sharing basis pre-agreed with the studio/network and Netflix, so the more times the unit was rented the more profit was realised leveraging economies of scale.

Streaming is different because it suffers from diseconomies of scale: as more popular rentals cost more to stream, a company will need more servers, and thus pay higher electricity bills. Add to that higher upfront establishment costs when entering new international territories, and profit margins are thinner. This means that to breakeven, Netflix requires many more subscribers in its home market (the US) than it did for DVD in order to achieve the same levels of past profitability – Moody’s estimated 35 million. Netflix has a solid base upon which to expand. It has increased its subscriber base by 4 million annually but that growth is slowing in the US market – hence the need for rapid expansion internationally.

In order to attract new subscribers and to reduce churn, Netflix must either pay premium prices for an exclusive window following theatrical release, as it has done with Disney in a deal that from 2013 provides Netflix with a range of Disney classics. From 2016, in a second stage deal, Netflix will have an exclusive window before pay TV for Disney, Marvel, Pixar and LucasFilm movies.

Add to this Netflix’s original programming such as Lilyhammer, House of Cards, and Arrested Development. Others will follow at the rate of five new series annually. These programs will premiere exclusively on the Netflix platform, which will allow it to differentiate itself from rivals.

Add value and package content at tiered price points

The traditional Pay TV model may become the preferred strategy for Netflix once Disney’s exclusive content deal activates in 2016 and Netflix has established its brand as a premium content provider. The key question is: if the only place highly engaged audiences can see a popular Netflix TV series or a Marvel or LucasFilm or Pixar movie in the first post-theatrical window is on the Netflix platform, will they pay a small monthly subscription? The history of pay TV indicates that they probably will.

Is Netflix the new HBO?

Netflix’s Chief Content Officer Ted Sarandos recently stated that Netflix’s goal was “to become HBO before it becomes us”.

In the fourth quarter of 2012, Netflix added 2.05 million subscribers in the US market, one year after the Qwikster debacle. With 25.5 million subscribers, if Netflix were a cable company, it would rank second behind HBO (28-29 million subscribers) and considerably ahead of Showtime (21.3 million) and the rest of the pack.

Netflix’s commissioning of quality original programming, combined with premium content deals, will offer a compelling and differentiated value proposition to online audiences.

Netflix and the future of TV

If the programming strategies of Netflix, Hulu, Amazon et al succeed, we may see the emergence of the first serious competitors to challenge industry incumbents. We already know that the future of home video is online, as the DVD and BluRay become obsolete. Online television services with potentially global reach could prove a serious threat to pay TV opereators and major networks in the looming battle for eyeballs and audience engagement online.

This article first appeared on The Conversation.