How Netflix Became Chill

It all started with a little red envelope…

Little did Netflix know when it launched its DVD by mail service in 1997, and officially when it switched its focus to streaming in 2007, it was creating the company, and more broadly the movement, which would disrupt the pay-TV business. Since 2011 in the US, cable subscriber growth has declined annually at 0.43% – a cumulative loss of 1.7M households[1] – while Netflix has grown subscribers at 19.87% – a cumulative gain of 23.1M households[2]. Netflix’s business model of spending heavily on off-air, and eventually original, content chosen based on big data analysis while charging consumers a much lower price than in-market alternatives, combined with its streamlined operating model of connecting consumers directly to content creators via the internet, have fueled this growth. Specifically, Digitization enabled Netflix to grow by creating a new, superior distribution medium and allowing for additional and highly relevant content creation. To sustain its growth, Netflix must continue to deliver high quality experiences that take up less bandwidth for consumers.

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Today roughly 1/3 of households subscribe to Netflix and Netflix is the #1 consumer of bandwidth in the US, at 35%, while the next largest, YouTube, is at 18%. However, this was not always the case. Netflix leveraged increasing internet availability and speed to disrupt the content supply chain by connecting consumers more directly with studios and content creators. Since 2011, US households with access to internet have increased by ~12M, from 79M to 90M[3]. Over the same period, average internet download speeds have increased from 4.7 Mbps (megabits per second) to 14.2 Mbps, an over 3x improvement which has greatly reduced buffering[4]. These digital innovations enabled Netflix’s new supply chain to deliver its content at quality levels similar to traditional cable distribution, but at a much lower price point due to the resulting business model changes this enabled. Traditionally, content creators (e.g., the NFL, Warner Bros. Studios) sold their content to TV networks (e.g., ESPN, CBS, TNT) who sold their networks to distributors (e.g., Comcast, AT&T, Dish) who in turn sold content to consumers. Content creators, TV networks, and consumers were dependent on the distribution owned by the Comcasts of the world, and suppliers had little flexibility in terms of how to get their content to consumers. The internet, and specifically its recently higher speeds, enabled Netflix to remove the distributors and serve as an intermediary between consumers and content creators. Using the internet as its distribution system allowed Netflix to reduce its price point and also to create a far superior digital-first user experience than the traditional set-top box of a cable subscription.

Netflix has mined its more direct relationship with consumers and that data has enabled it to be highly successful in acquiring off-air content but even more so in making original content. In 2016, Netflix received 54 Emmy nominations for its original content, behind only FX and HBO[5]. Netflix’s direct relationship with customers gives it a keen understanding of what content its consumers watch. For example, when Netflix chose to buy “House of Cards”, it analyzed 30M plays per day, 4M ratings by Netflix subscribers, 3M searches, and the overlap between viewership of Kevin Spacey (lead actor) movies and those of David Fincher (executive producer)[6]. This data is orders of magnitude superior to the basic demographic data that Nielsen provides to TV networks, which is based on viewership across 40K representative households in the US and is simply broken down into demographics (women 18-34, men 35-49, etc.).

In order to sustain the growth that digitization has enabled, Netflix must continue to deliver hits but take up steadily less bandwidth. In terms of content, Netflix is spending heavily at $3.2B in 2015, much higher than HBO’s $2.0B. By mining its data on millions of subscribers Netflix must  come up with hit programs that create exclusivity, especially as Amazon Prime gets more serious about video by doubling its content spend in the second half of 2016 compared to the prior year[7]. Netflix must also optimize its streaming methods as it offers more 4K content (extremely high quality picture) and internet service providers continue to increase prices for higher bandwidth packages. With the right content and digital strategy, Netflix should be able to continue to eat the traditional cable industry’s collective lunch.

 

(800 words)

[1] SNL Kagan Multichannel Industry Benchmarks, https://www.snl.com/web/client?auth=inherit#industry/multichannelIndustryBenchmarks; accessed 11/15/2016

[2] Statista publication of Netflix Quarterly subscribers from SEC filings, https://www-statista-com.ezp-prod1.hul.harvard.edu/statistics/250937/quarterly-number-of-netflix-streaming-subscribers-in-the-us/, accessed 11/15/2016

[3] Statista publication of Leichtman Research Group Data, https://www-statista-com.ezp-prod1.hul.harvard.edu/statistics/217938/number-of-us-broadband-internet-subscribers/, accessed 11/15/2016

[4] Statista publication of Akamai data, https://www-statista-com.ezp-prod1.hul.harvard.edu/statistics/616210/average-internet-connection-speed-in-the-us/, accessed 11/15/2016

[5] Statista publication of Academy of Television Arts & Sciences, https://www-statista-com.ezp-prod1.hul.harvard.edu/chart/5282/emmy-nominations-2016/, accessed 11/15/2016

[6] “Giving Viewers What They Want”, Carr, David, New York Times, 2/24/2013

[7] “Amazon Just Quietly Showed How Ambitious It Is With Media”, CNBC, 7/29/2016, http://www.cnbc.com/2016/07/29/amazon-just-quietly-showed-how-ambitious-is-it-with-media.html

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11 thoughts on “How Netflix Became Chill

  1. The numbers around user growth for Netflix drives the point home around how successful Netflix has been in making customers less reliant on cable subscriptions. As Netflix continues to attract customers, how does Netflix handle the issue of TV networks creating their own streaming services to capitalize on streaming services, like HBO with HBO GO? Will Netflix look to integrate its platform with TV networks, like what Hulu has done through a partnership with Showtime? Also, as how will the economics of purchasing content from content creators be affected as Netflix continues to create content thereby taking away eyeballs from purchased content? Will the margins on purchased content be diminished to the point that it is no longer economical to purchase rights to the most expensive content? I’m curious to see how Netflix will continue to disrupt and industry where it is angering many powerful, incumbent giants.

  2. Great article Ross; very interesting. Where do we currently stand on the battle between the ISPs and the content providers (i.e., Netflix, Google, HBO, etc.)? I followed this back when FCC was investigating the issues around bandwidth throttling (i.e., Net Neutrality) where they ruled this illegal; however, have not kept track much since. Have the ISPs responded with significant rate increases then, or if not, is this a threat in the future that would impact Netflix’s growth plans?

  3. Ross, this article is a great way to capture one of the most significant digital disruptions out there.
    If you’ll allow me, I would be curious to get your take on a serendipity of the small revolution Netflix started by becoming a content creator.
    It used to be that TV shows were all written to accomodate what is called “mini cliff hangers” every 10 minutes or so. All Hollywood writers used this as a technique to have the end user sit through the commercial break dying to see what is next to happen on the show, once the break is over.

    Netflix by becoming its own content provider to some extent, shattered this constraint and by doing so, allowed for a more “linear” writing in the shows it produced. TV/Streaming commercials represent a huge business, as future TV shows evolve to follow more a linear plot as in House of Cards, this is another business Netflix might be destroying without even noticing it.

  4. Great article, Ross! The Netflix story is fascinating. What do you think are the biggest obstacles they will face while trying to take up less bandwidth and continue to generate attractive content? How significant of a threat do you really think Amazon Prime Video is to the Netflix model? I read recently that Netflix had expanded into 130 international markets but growth there has been slower than expected – perhaps due to the fact that broadband Internet access is not as widespread in many developing countries. Has this trend in their performance reversed at all?

  5. Ross, I find this article very fascinating. I never strike me (until you pointed it out) that, given its’ data, Netflix has much better analytical ability than any other service providers. Hence, the firm can pick the best content for its customer base. A perfect tool to assess demand for the content. Furthermore, I think Netflix can (if not already) use this information as an input to create its owned shows. For example, they would be able to pick better actors and actresses, genre, etc. It would be very interesting how the science of determining customer preference meets the art of creating content.

  6. It’s fascinating to see how far Netflix has come in only a few short years. The company has fundamentally changed the way people consume media, tapping into viewers increasing preference to binge watch programs and using these insights to formulate their own strategy, such as releasing entire seasons of content all at once. However, I wonder what the future response will be from the rest of the industry as Netflix continues to compete with incumbent players through developing its own content. Will these companies ever be incentivized to block Netflix from acquiring their content? Also, how will Netflix continue to differentiate itself from other competitors such as Amazon who are also beginning to develop their own content? While the company has been able to deftly navigate through its competitive environment up through now, it will be interesting to see how it continues to balance these increasing industry pressures going forward.

  7. I was pretty skeptical when Netflix made the move to start producing its own original content a few years ago, but I can now see that this is such a smart move–it seems that the cost of acquiring content rights is becoming increasingly expensive due to competitors driving prices up (see link below) and also the fact that Netflix is being seen as a much more serious threat to the viability of traditional media delivery. Producing original content tailored to its user base will ensure a smaller portion of their investments being “duds” by supplying consumers with content they don’t actually want.

    The net neutrality issue is definitely worrisome for netflix, and since they use such a massive amount of bandwidth, I doubt that the issue is resolved forever. I think Netflix should be careful with introducing 4K due to this fact–bandwidth usage will skyrocket further and may open up more aggressive challenges by ISPs who will have to scramble to continue delivering minimum levels of speed to their customers.

    http://www.nasdaq.com/article/why-there-wont-be-a-notable-improvement-in-netflixs-domestic-contribution-margin-in-the-future-cm698980

  8. Great post, Ross! I really enjoyed reading about Netflix and the Company’s rise to power. I must admit I was shocked that Pay-TV has only declined at a 0.43% CAGR between 2011 and 2015 (I would expect the decline to be much more significant!). You highlighted this in your post, but I believe that Netflix’s consumer data is a true competitive advantage. It is impossible for cable to compete with them on their data/predictive analytics because it is true, cable really only has access to basic demographic data that is generally much less helpful. I hope ESPN is ready to handle this type of pressure and competition 🙂

  9. When thinking about future growth, I thought it was fascinating that the CEO acknowledged the possibility of entertainment substitutes from VR and hallucinogenic drugs (http://www.theverge.com/2016/10/24/13400254/netflix-reed-hastings-replace-movies-tv-drugs). Maybe the transformation that we’ve seen in distribution will actually be a drop in the bucket compared the transformation on the horizon due to even strong technological forces. These could impact the content itself more than the distribution. There’s a terrific non-fiction book about the end of the silent film era, the End of the Parade, which interviews the old actors, directors and artists the made the silent film era possible. They were wholly unprepared for the new medium of sound and color into film, and were largely left behind while a new cadre of artists and studios took charge. Perhaps Netflix will be able to adapt and shape the emerging field of VR entertainment and not limit it self to the traditional movie format.

  10. What Netflix did — migrate from DVDs by mail to streaming video — was impressive because (1) they took a big (i.e., caped-intensive) bet at the right time that people’s media consumption habits would move towards streaming, and (2) they were able to do so (i.e., change their entire operating model) so quickly. I didn’t fully appreciate just how much of their operating model changed. It just wasn’t the technology, but it was also, as you mentioned, a complete change to the content creator / distributor / consumer relationship. (And it makes much sense why they would move to original content.)

    I’d like to expand on your point about Netflix’s ability to mine user data to draw insights about behavior and preferences. Netflix’s recommendation engine has been cited as an example of a company flexing its big data muscle. The company used to host contests to data scientists and developers to design a better recommendation engine, offering prizes as large as a million dollars. A lot of technology is behind the content Netflix suggests you watch!

    I’d also like to look at the concerns you surfaced, around what Netflix needs to do as it grows and expands into video formats such as 4K, from a technology perspective. Netflix is still on Amazon Web Services and I speculate is AWS’s largest customer (especially after Dropbox moved to its own data centers). The newer formats require even more space and bandwidth, which means higher AWS spend and greater dependence on that service. Does Netflix need to think about building its own data centers, as Dropbox did? It was be an immensely huge capital expenditure for the company, but it would give the company greater control over its cost destiny.

  11. Great article Ross! I agree that Netflix’s model has been truly disruptive and that it probably changed the entertainment industry forever. That being said, a few questions remain. I wonder what the long term strategy of distributors will be. Are they destined to extinction or will they find a way to reinvent themselves? Moreover, given the trends in viewership, how will companies advertise their products and services? Will we see advertising in Netflix in the near future? Will the consumer accept this? Lastly, I think it will be interesting to see how in-house content creation evolves. I do not know if show like Game of Thrones, which are extremely expensive to produce, will be sustainable in the long run given the trends in advertising. Will Netflix and HBO be able to find new sources of revenue?

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