Netflix Business Model & Economics

Bobby, can you share some context to your role and responsibilities at Netflix?

I was fortunate to work for Netflix from 2013 to 2017, so four years with the company as it was expanding globally. It was in 30 countries when I got there and 180 by the time I left. I was fortunate to be part of that expansion and saw what went well and what didn't. The other big initiative, during that time, was the Originals initiative. Today it just seems that's what the company is, but during my tenure it was licensing heavily. During my first week they had just launched House of Cards, whereas now they launch an Original every day. My role largely focused on those two big company initiatives – how you sequence the countries and allocate capital into those markets to acquire subscribers, which shows perform best and how to market those shows. I had to think about pricing and everything in between just to grow the service. I was in a proper planning group working to allocate capital across those regions.

How did you look at modeling subscriber growth in the US?

Netflix looked at it in a couple of ways. When folks want to think about it, the addressable market is broadly households. Just because you have a TV doesn't make it enough to get Netflix; we know you need a broadband or at least a high-speed connection of some sort. In the US there's about 80 to 90 million broadband households. They look at that as their ceiling. For several years they put out the long-term view, when they were much earlier in the investment piece, saying we think in the US we can get 60 to 90 million, where cable and satellite packages of 50 to 100 channels went; we're much lower priced and more convenient, so why can't we do that? They've already passed the 60 million mark, domestically. Can they get to that 90 million to match where cable and satellite bundles have been? It's a little harder to imagine with the product now, having no live news or live sports, that it's a full replacement for cable television. Will they get to 90? It seems further away. I believe their question around forecasting the subscriber growth; it will be lower in the US and they're very explicit about most of the growth being international.

That is looked at similarly. How many homes had a pay TV package and are willing to pay $50 to $100? Now we pay $15 for a Netflix subscription which gives you a comparable amount of content, a better personalization, recommendation on demand across any device. Still not that live viewing, still not maybe as much local content as you might have expected, although they're getting better at that. I think they look at those penetration rates of where cable packages got to, where broadband is in a country, as a pre-cursor to them, which in some developing nations is harder. As they move into developing nations like India and others, they might even forego those proxies and look at a little more mobile penetration. India never had widespread 100-package cable channels for $50 a month. They never really even had broadband adoption at scale, moving straight to a mobile infrastructure instead. They'll think about it very differently with lower price points, but the key value is that they believe entertainment of TV and movies is a universal value proposition. This will, in many ways, replace the existing channels, just like smart phones replaced land lines. It is only a matter of time before streaming video services replace linear television packages. Whether that takes two services or three services or one, Netflix helps to be part of the mix. You're talking about a very big market that has been built over a century of TV infrastructure, which is now shifting to a digital infrastructure. This is merely a replacement versus a new category that exists on top of it.

Given Netflix are at 73 million subscribers in the US, it could be likely that they might be moving into news and sports relatively sooner than expected, if they want to get to that 90 to 100 million mark?

I'll take the other side of it. I don't think they want to move into it, nor do they need to for growth. I think to further saturate the US, they would probably move into news and sports more aggressively. They are growing just fine in the US and are growing even better internationally, so I don't think they have to. I think they would do that as a distraction tax for a few reasons. If they were to move into news and sports, live is largely supported by advertising. Advertisers pay a premium and people don't skip the commercials as much. Do they want to go out and build an ads sales force of hundreds and thousands of employees, insertion of dynamic ads, data which Facebook and Google have been collecting for years to do this at scale? It is beyond their focus right now, especially when they have this massive opportunity to take what they've already done and port that over to new countries with different content. They're dabbling with news and sports and reality and other categories and they'll push those. But you'll see non-scripted, the reality competition shows they're doing, before news and sports. Sports is extremely challenged and maybe that will shake out over the next three years, but I don't see it as a near term focus.

Can't they bundle sports into a premium plan, rather than ads and have a premium tier, for example?

Certainly, I think Disney does that very well with Disney and then you add Hulu and then you add ESPN and it costs $5, $15; it's cheaper when you get all three. They could, and that would be a strategy to raise price, which they're doing effectively. They just did a $2 price increase a year. They're talking about great retention, they're growing the US base, despite being saturated, which means retention is in play, and they're able to move price up across the globe over time. Why add more content that requires more cost and all of that? Secondarily, the sports rights are locked up for a longer time, so they don't come up. Every time they do come up, the conversation with Netflix comes up. Will they bid? Will it happen? One of these days it will be true, but I don't think in the next 18 to 24 months any of those rights are pending. Netflix would not have the technology to go there. There will be a point where Netflix's growth slows and they have to look at those spaces, to see if it makes sense for them, just not in the near term.

In the early days, you were modeling subscriber growth on number of households in the US, plus the broadband or smart phone penetration or iPads, for example, to get distribution. As we do get to saturated markets in that sense, does it shift more towards content and new content driving growth?

I think there's still an underlying seasonality that exists, just like in most industries. Summer has always been a big movie season, minus this year. People went to the Summer box office, theaters put their best movies in that disproportionally. Retailers disproportionally benefit in the holiday season, to make most of their sales or back to school. There is a natural seasonality to streaming video and, for the last decade, that has largely been around Q4 and Q1 where people buy devices, device manufacturers launch new TV and home electronics, and then they sign up for Netflix, because that's what those smart devices do very well. You'll always see a disproportionate sign up period around Q4 and Q1, but that's what any analyst can predict.

When you can outperform and underperform, maybe it's because you have some content that helps lift the quarter. You were going to get a million subscribers in Q4 anyway, just because that's when Apple and Samsung release their new devices and, all of a sudden, Netflix reports at 1.5 million. They might have just had a surprise success with one of their new Originals or a second season, so Originals can bend it. It doesn't usually take that million to 2 million, but 1 to 1.2, and it's usually not a single Original. They're now putting together a series of things like Tiger King, an action movie and a returning season of The Crown, all in one quarter. They launch it together which helps it improve. Content can increasingly overperform or underperform, but there is still an existing adoption cycle that is going to happen. If Netflix did no marketing or new content, a user would say this is a superior product compared to my linear television package which is three times as expensive, half as convenient and half the selection, with commercials. That will naturally happen as people say this is a better product, and it will happen even faster as the content is excellent.

How does Netflix look at pricing in the US?

They just commented on their last two earnings calls that they're not looking at a price increase. They have taken $1 each of the last two years, and then $2, if my history serves me correctly. Each time when they do that, they produce a little bump in churn, existing customers get a little frustrated, new customers maybe a little less apt to go. Then they have a slower growth quarter and the doomsayers come out and say this is the end. Further quarters down the line, you will see it come back. They take their time and they usually talk about the fact that they've earned the right to increase the price. They're spending significantly more in content, the product is significantly better, with better recommendations, better marketing, better customer service and customers are, essentially, retaining better than they ever have. For that product, they say they're going to charge you a little more.

Netflix are now spending $15 billion in content versus $10 billion, which means the number of shows and movies that can be produced at the actual level are there and, therefore, they think they can charge you a little more. They think very actively about price, but in the US, they are smart and sensitive to the time the world is in right now – where we are in a severe recession, potentially depression – and there is a lot of scrutiny around internet companies and their power. I think they are going to be very careful there. The real question, if you look at more of a five-year view, is do they have pricing power domestically? I absolutely believe they do. They're going to continue to accelerate their spend, the number of shows and categories such as unscripted theatrical movies they are investing in. I think that will, eventually, result in what Disney is now doing. Disney is experimenting with bringing a $30 super premium movie, like Mulan, which was supposed to go to theaters, and bringing it onto Disney Plus and expecting consumers to pay a regular subscription fee, plus $30 on top. Netflix would take that same movie, that is maybe on a par with Mulan or The Irishman, and give it to users for free.

Eventually, they are going to say, you are getting these movies at Disney – who are charging you $20 to $30 – so we are going to increase our price from $13 to $15. They are still not the price leader, as they are behind HBO Max which is $15. Netflix has a $15 price but its average user is not there, as they are on a lower tier. They have a chance to move people up those price tiers, but I don't foresee that happening in the near term. They have that option when they choose to exercise it and I expect them to exercise it very diligently and thoughtfully.

In terms of exercising that pricing power, is that determined mainly by content spending or do they look at viewing hours or other variables to determine that?

I think it is about content viewing and, more directly, retention. I don't think they have a material view; if you used to watch 10 hours and you retained but now you only watch five hours and you retained, it's still a retention. Obviously, they would like it to be 10 and retained, but I think they are less focused on total hours of consumption. They used to release reports showing a billion hours over the holiday, Amazon streaming, representing X percentage of all internet traffic. Although impressive, do I think they would rather you watched 2.5 hours of The Irishman than 10 hours of re-runs of Friends? They're probably indifferent, but The Irishman represents something they will have forever. It is an IP associated with them that will never go away. Friends is going to leave and go to Warner or a different service in future, so all hours are not created equal. Certainly, we know if you watch more, you retain more.

Retention is a signal that I am willing to pay you $13 to $14 a month and I'm so willing to do it that I might even pay more, because I've been with you for three years. That is the first factor, but will this turn off the 190 million subscribers they currently have and create churn, like the scar they have from the DVD Qwikster days, when they had the service? They separated and did an ill-timed pricing increase which resulted in massive churn. Ever since then, they have been more thoughtful about it. They will ask their users for permission. They have implemented grandfathering in the past, so they will do it as thoughtfully as they can, but it will be driven a little less, so that it can sign up the next 10 million members without alienating the existing 200.

It is an interesting strategy from them, because they are obviously priced very low and it is a great offer for what you get. That was a conscious effort in using the price to almost subsidize or fund the growth, in effect, by giving such value to the users, but I guess the big challenge now is moving that up to make that free cash flow from Netflix?