It Could Be Said #26 Netflix's Fatal Flaw
The streaming giant's response to a shock fall in subscribers continues to show that it doesn't understand the fundemantal flaw in its business model
It has been bad couple of weeks for Netflix, with the industry leading in streaming video rocked by its first ever loss of subscribers in a quarter. It has responded with a wave of budget cuts, including cancelling programmes and firing staff members, whilst its stock is trading at less than half the price it began the year at.
So what just is going wrong at Netflix?
Nothing to Monetize the Video Star
Star When talking to my good friend Steve Harwood about my belief that streaming services cannot be the future of the movies, her go to counter example is the music industry. After all, the music industry responded to the challenge posed by file sharing sites such as Napster by embracing legal online streaming, based on the calculation that the pivot to online music was inevitable, and it was better to get some revenue from legal sales than nothing due to piracy.
After all, whilst that transition was painful and expensive, we clearly still have a music industry today. But that shouldn’t be a surprise given that we had a music industry BEFORE people could buy music to listen at home. Musicians may grumble at earning pennies from thousands of streams on Spotify but few pull their music from the service because they appreciate its good advertising for where they now make their money – live touring and merchandise. Now more than ever, recorded music is the promotional materials for the real product of getting to see your favourite musician live in person, a business that was booming before the pandemic and rapidly recovering now things have opened-up.
What all this and similar success stories have in common is that what they’re losing in making the product cheaper for the masses, they’re gaining some of it back by super-serving their hardcore fanbase. The emphasis on what is becoming cheaper obscures what is becoming more expensive. Of course, there is a very good reason why the eye is drawn to what is becoming cheaper – more people benefit from the former than lose on the latter. For every fan a successful musician has that would seriously consider going to one of their concerts, they will have hundreds if not thousands who are quite happy just listening to the songs at home. That ratio probably stretches to the hundreds of thousands or even millions when it comes to fans who would want to go and see a musician more than once.
It has always been true that most businesses make most of their income from a small minority of their customers. The trick to maximise revenue is to maintain the lowest possible price of entry, whilst rapidly escalating revenue as customers become more engaged and active, because more casual fans automatically mean more opportunities to convert people into hardcore customers.
There was perhaps nothing better at gaming the Pareto Principle than television. The price of entry was nothing more than buying the magical video box and, in some countries, paying a nominal licence fee which paid for the broadcast infrastructure and some public service broadcasting. Once they had you watching, the revenue television companies would track the intensity of your investment in their service. At its most basic the more shows you watched the more television companies could charge companies to promote their products during them. If you loved a particular show then maybe they or the creators could sell you tickets to a live version of it, such as when I met my then hero Sooty in Loughborough Town Hall as a child. As technology advanced, they could sell people videos, DVDs, or digital downloads of their favourite show. Ultimately, they could sell the foremost tele addicts better channels such as HBO or Sky Sports for a premium fee.
When you break down television’s model like this, you realise why Netflix keeps running into trouble. Not only did they raise the price of entry compared to television in most countries (even in Britain, Netflix is rapidly approaching the cost of the BBC Licence Fee despite offering a fraction of the service), which explains why even now it and other VOD services makeup a minority of viewing time. The nature of Netflix means that it cannot resell the programme you just watched, because, well, you can just rewatch it through the same service. Worse they ignored the things they could mimic television, by eschewing developing a robust merchandise division, offering premium programming, or including adverts.
And that is Netflix’s fatal flaw.
Michael Scott Streaming Service
Netflix’s argument about why it could either cannibalise or eschew revenue streams that are essential to more established television companies’ profitability is that they could gain a much greater subscriber base. Forget the depth of revenue, feel its breadth.
The problem that this came up against is that a service cannot keep expanding its customer base without reducing its Return on Investment from each individual customer. This is because beyond a certain point each additional customer costs more to attract than the ones that went before. With regards to Netflix we’ve seen this with their expansion overseas, which has required Netflix to not only accept lower payments from subscribers but also produce or purchase non-Anglophone content that usually has little appeal to its core subscriber base
This was exactly the issue that the Michael Scott Paper Company encountered, where despite its CFO’s fixed projections, it couldn’t grow its way out of losses because costs would dynamically increase alongside growing business. In addition to the aforementioned challenges its overseas expansion has encountered, there’s also been the other problem that content providers have increased what they charge Netflix as they realised how important streaming rights were. Indeed, there’s no better example than the US Office, where NBC Universal rejected tens of millions of dollars to bring Michael Scott and company to its own streaming service, Peacock.
But just like the Michael Scott Paper Company, there’s no way to grow your way out of a bad business model. Netflix’s latest financial reports once again show the company having negative cash flow and spending away it’s reserves, despite all the funky calculations Netflix indulges in to pretend its profitable. Bizarrely, Netflix has responded to its latest setback by promising to investigate Peacock’s “innovation” of having an ad-supported lower tier. This announcement should be the biggest red flag about the future of Netflix, with the company scrambling for yet more gimmicks to increase its subscriber base even if that means cannibalising revenue from existing subscribers. The only idea Netflix seems to have to keep the good times going is reporting more and more subscribers to investors every quarter so they will keep lending it money.
The mass sell-off shows that people are starting to see through the streaming giant.
They Are On The Clock
I made my bones as a VOD sceptic with my caustic commentary of the WWE’s premature pivot from pay-per-view to a subscription service. One of the more infuriating aspects of those dark times was the forced emphasis on minutes watched, with WWE abusing every cheap trick in the book to stretch the amount of time hardcore fans were watching the product.
Looking back what is striking is that such statistics literally meant nothing. WWE made as much money from somebody watching 3 hours in a month as somebody watching 300 hours. There was no business reason to care about how long people were watching the service, because there was no mechanism to monetize the most hardcore viewers. The WWE solved this issue by selling the library to Peacock, but Netflix is still in denial about the giant flaw in its business model.
Streaming can only become profitable and sustainable if it develops a way to monetize its most dedicated customers. One route is for streaming to be part of the larger companies who leverage a loss-leading subscription service to support the wider business. Nobody is better positioned to do this than Disney or Amazon:
Whereas Netflix is closing down its animation studio amid recrimination about lack of promotion and merchandise, Disney can use its Disney+ television series to fuel interest in future theme park attractions, toys and other merchandise items, and even cinematic movies
Disney is experimenting with pay per views, selling films as premium content on Disney+ and has already achieved real success through making ESPN+ the North American home of UFC PPVs.
Amazon Prime makes up with a lesser basic library than Netflix by being a platform where people can purchase individual premium films or premium channels.
Amazon’s streaming service is sold as perk to encourage people to signup to the Prime delivery service
Both companies can use the data they gather about what people watch through their subscription service to develop new merchandise and premium video content
Netflix on the other hand is just a video content company. The stuff it sells for a flat subscription rate is its one and only product. Netflix has attracted the biggest subscriber base in the history of entertainment, but it has no way to monetize its hardcore audience as everyone pays the same regardless of how much they use the service. And by offering new gimmicks to get more low-spending casual users Netflix further demonstrates it just doesn’t understand the depth of the hole they’ve dug for themselves. They have a business model that may have just about worked when battling movie channels and video rental stores, yet they instead declared war on the entirety of Hollywood. They’ve kept the wolf at the door by alternating between overspending on a few tentpoles to hide how they’re increasingly becoming lowbrow and cheap with the vast majority of the content they provide.
If Netflix wants to thrive then it needs to recognise that its business model is fundamentally flawed, and that flaw is that it doesn’t monetize its hardcore fans. Cutting costs doesn’t solve the fundamental flaw, and just risks making them a more attractive proposition for other media or technology companies to buy. If it wants to stay independent then it needs to develop a strategy to monetize its hardcore customers. The obvious moves would be:
Carry advertisements throughout the service so that Netflix can monetize individual viewings rather than just individual subscribers. In theory Netflix has the data to be a powerhouse in digital advertising.
Introduce a premium tier that gets Netflix Originals TV Series as a one-off content drop, whereas everyone else gets the shows drip-fed on a more staggered basis
For popular or prestige content develop extras such as outtakes, commentary tracks, making of documentaries that you sell to subscribers for an additional price
Netflix Original Movies are made available on PPV whilst they’re doing their limited theatrical run to qualify for industry awards
Copy Amazon and allow smaller subscription services to use you as a platform
Of course, the obvious problem with these suggestions is that they complicate what is a very simple and clean interface to use. I think that objection is sometimes thinly disguised special pleading by people who understandably enjoy benefiting from massively underpaying for unlimited video content. But if you did want a cleaner system then the alternative would be to adopt a tech-focused pricing strategy than a media-focused one. Rather than organise tiers around the availability of content you could organise them by its consumption, with subscribers who pay more being allowed to watch more hours, just as people who pay more to their mobile phone company get to call/text people or use mobile internet more. Of course, it would be a huge shift in Netflix’s product to impose limits on how much content people could consume.
If you recoil from either plan for Netflix’s future maybe you need to check your self-interest. It has been a wonderful decade to be a hardcore “content consumer” but as full employment, resource scarcity, and high inflation return the jig is up; hedge funds aren’t going to continue to fund the present on the promise of a future that will never come.
If you don’t think Netflix is a service worth paying more for through the various strategies I’ve outlined here, then maybe its time to accept that the future should look remarkably like the past, with advertiser supported television and movie theatres still preeminent. Sometimes the old ways really are the best.