Netflix: A need for a Dual Transformation in its Business Model

Painting a rosy picture for the market isn’t something new that companies do to push up their stock price, and it looks like Netflix too has joined this bandwagon, albeit more aggressively.

Netflix has recently changed its metric for measuring ‘viewership’ from watching 70% of a show, or film, to watching a show, or a film for 2 minutes. Now that’s a drastic shift!

The result – The new reporting metric has pushed the viewership higher by 35% as compared to the older metric.

Let’s try to understand this shift in the metric definition in much more detail –

Old metric definition – Watching 70% of a show or film

Caveat (Applicable to TV series): ‘ How to get enhanced viewership ’

• Shows need to hit this 70% mark within a single episode to count it as ‘viewed’ i.e. if a user watches 70% of the first episode of any season of a show, Netflix would deem the user as a viewer of the entire season
• Considering a normal season of The Office, ~20 episodes each having ~20 minutes of running time, watching just the first 14 minutes of the first episode would mark a Netflix user as a viewer for the entire season (A view is considered by just watching 3.5% of the entire season)

We’ll now try to estimate the average ‘viewership’ time via the old metric – 

Considering that minimum 50% of users actually watch the entire season and not just leave after watching 70% of the first episode of the season, the average viewership time via the old metric comes out to be ~45 minutes.

New metric definition – Watching a show, or a film for 2 minutes: ‘ How to get enhanced viewership: Pro ’

The day is not far away when Netflix further updates its viewership metric definition to just watching the trailer or even hovering over an episode or a movie (‘ How to get enhanced viewership: Max Pro ’)

Compared to the old metric, the new metric reduces the threshold for viewership by 96%. Despite such a huge reduction in viewership threshold, Netflix saw that viewership increased by only 35%.

If you’re betting on Netflix’s longevity surely this doesn’t bode well for the entertainment service. So why was Netflix compelled to change its viewership metric? Netflix is facing extreme challenges on the OTT (over-the-top) platform front as a result to reinforce investor confidence into its business, the viewership metric was recently updated.

Challenges in-front of Netflix

Increased competition in the OTT space

Contrary to popular belief, TV viewing is still a major source of leisure time entertainment for people. This means that multiple OTT platforms are vying for that same ~2 to 3-hour leisure time window every day.

Hence to attract customers towards themselves, OTT platforms are providing their services either for free or at highly discounted rates, thereby shifting customers away from Netflix.

A singular focus on providing entertainment services (No ancillary focus)

Other competitor OTT platforms such as Amazon Prime, Disney, Apple TV etc. plan to use OTT as an ancillary for their main business i.e. OTT will not be the money-maker but rather OTT will be an enabler for their core-business to make more money.

While Amazon wants users to buy more from its e-commerce vertical through Amazon Prime, Apple TV wants to encapsulate more customers into the iOS environment by selling new services to people outside its current ecosystem.

Similarly, Disney wants to control the entire content distribution chain right from content creation to theatrical distribution, and marketing thereby controlling costs. Additionally, Disney also plans to increase the overall view-time of a household through its offerings for each age-group (animation, sports, movies, etc.) and increase customer stickiness.

On the other hand, Netflix only deals in providing users with a plethora of shows and movies and hence has nothing else to bank on to drive customer retention with. As a result, by providing good content and undercutting on price, competing OTT platforms are taking up Netflix’s share.

Difficult to maintain income statement dynamics – Reducing Customer Retention and High Operational Costs

Long selling cycle, ever-increasing content costs and big players withdrawing shows / movies have a direct effect on customer retention and operational costs.

Big banner deals such as contracts with Disney, Warner Bros., and other TV show networks take approximately 3-4 years to materialize, with the nature of these deals being short term. E.g. – If Netflix signs a deal with Disney in 2015 to stream Marvel’s content, the movies will start airing on Netflix in 2018/ 19 for a short period of 1 – 2 years (contract-depending).

Given that big players such as Disney etc. are entering into the OTT foray, they naturally want to capture the market share away from Netflix. Despite the fact that Netflix has seen some increased customer retention with its high-quality original content production, retention of its subscriber base is still highly hinged to it streaming these big banner productions’ content.

By elongating selling cycles, increasing the content licensing costs and not extending content licenses to Netflix, the big banners are trying to lower Netflix’s customer retention, while increasing operational costs at the same time. The effect of an increase in costs would mean an increase in the subscription fee, which would further lower Netflix’s customer retention.

High content production costs

Netflix spent $15 billion on original content creation and the spending is further going to increase in the future. The high content creation cost coupled with slowed down customer acquisition is making matters worse for Netflix.

With most of the subscriber growth coming from overseas markets where subscription fee is lower, Netflix will now find it even hard to recoup its investment. Hence, to cover for the high content costs Netflix again would have to increase its subscription fee, which would hamper customer retention and make it easier for competing OTT platforms to attract customers.

Let’s try to estimate the Customer Acquisition Costs here –

Considerations:

• Netflix added 13 million new international subscribers (outside US, and Canada) in the 1st quarter of 2020
• Assuming the same trend we can say that Netflix would add 52 million new subscribers this year
• This accounts for 28% of its total subscriber base of 183 million subscribers – We’ll assume the same growth numbers

Results:

• Based on the assumptions above, we can easily extrapolate that 28% of $15 billion is meant for fueling customer growth
• This gives us a customer acquisition cost of $80 / subscription, with the average subscription fee being $11 / month
• Given that an account is shared by 4 people, it’ll take Netflix approximately 2.5 years to recoup its investment

Please note – While Covid-19 has helped Netflix pick up substantial customer growth, this growth will not be sustainable. Having said that, Netflix has no plans to reduce its content production costs.

Therefore, in a normal scenario, Netflix would require ~4 years before it starts getting a return on its international subscriber expansion investment.

Given the above challenges, it’s imperative for Netflix to change its business model and try to capture as much market value as possible.

Netflix can transform its business by doing the following (Dual Transformation):

1. Repositioning its existing business to maximize long-term viability
2. Expand into synergetic business lines to capture more value and create a new growth area

Expand into synergetic business lines to capture more value and create a new growth area

Netflix has built a strong capability in delivering online content and building a recommendation engine tailored to user preferences

Synergy with delivering online content: Ed-Tech business (Education and Technology)

Way before Byju’s and other ed-tech platforms came into existence, Netflix tried its hand at catering to the school going children through its vertical called Guaranteach. It was a platform where teachers could host short videos teaching different subjects.

Students went through a simple diagnostic test, through which Guaranteach tried to learn about the child’s learning style and behaviour. Guaranteach then provided custom material to children tailored to their learning style.

However, the platform suffered from poor child engagement and eventually, Netflix sold it in 2011.

The reasons for low engagement were two-fold –

The inability of customers to look away from the ‘ leisure ’ tag

While Guaranteach was meant for school going kids, Netflix only focused on adults. With the core business being ‘entertainment’ focused, an education-based extension was considered gimmicky and couldn’t be taken seriously by potential customers.

High costs

High levels of personalization meant high costs. Since different kinds of teachers excelled in providing different kinds of services, onboarding multiple teachers on the platform coupled with hosting so many videos proved to be costly.

Given the failure in the ed-tech space, is there anything else that Netflix can do?

Netflix has one of the strongest AI, ML algorithms in place and it consistently tries to improve on its recommendation engine, either internally or through the Netflix Prize, to provide top-notch levels of personalization to its customers.

What if Netflix were to start its own Data Science training programs (and for similar related fields that Netflix holds expertise in) for young graduates and/ or working professionals? Imagine having a Netflix proctored Data Science certificate! Wouldn’t it be so cool?

What advantages does this entail for Netflix?

Ability to price the program with a high premium

Given the respect Netflix’s AI-ML algorithms command in the industry, Netflix can premium-price the program and create a standalone, high value offering for prospective customers (Much like MS Azure, AWS certification etc.). Netflix can obviously keep a slightly strict eligibility threshold for the program to make the program genuine and attract interest from serious customers.

No customer-offering mismatch

Unlike the Guaranteach offering, where-in the user (children) and buyer (parent) were separate, the Data Science program’s user and the buyer would be a slightly experienced Data Science expert itself. The fact that these potential customers would already know the value that Netflix’s algorithms carry, would remove any qualms about the seriousness/ quality of the program.

Reduced cost of improving internal operations

As a final project, the customers can be given an improvement project that can remove an existing pain-point, say improving the recommendation engine, A/B testing for certain features etc. This has the potential to significantly reduce the cost of operations along with a reduced implementation time.

Synergy with building tailored recommendation engine: Improving health outcomes – Health–Tech

Netflix boasts of a strong recommendation engine that tries to predict a user’s preference or behaviour by capturing n number of data points. The same can be applied to healthcare!

By capturing a lot of data points and using its strong recommendation engine, Netflix can help insurance firms, hospitals, and individuals in predicting patient health and improve patient health as a whole.

Imagine a doctor examining a patient and filling in details in a system that displays all possible diseases a patient might be prone to! The benefit? Increase in efficiency of the doctor, lowered time for patient diagnosis and better patient outcomes.

Imagine an insurance provider knowing beforehand what diseases a patient is more susceptible to! The benefit? Personalized insurance plans, better risk management, and helping patients take corrective actions beforehand, therefore, reducing claims amount.

Imagine a hospital being able to predict which disease profile is going to spike up in the coming months! The benefit? Improved ICU management, medicine ordering optimization, and efficient workforce allocation leading to improved cost management.

If executed well, ed-tech and health-tech can provide massive wins for Netflix!!

Repositioning its existing business to maximize long-term viability

To ensure customer retention, Netflix needs to lower its subscription fee while also focus on providing top-notch in-house original content to ensure customer loyalty and that customers find unique value in the offerings.

But how can Netflix make up the revenue lost from reducing subscription fee?

Here’s a crazy thought, why not replicate the traditional business model of theatres?

Netflix can charge a minimum subscription fee of Rs 100 – 300 per month for providing users with big banner production’s content, and then charge users for Rs 100 / 150 per season or movie on top of it for its in-house original content (much like YouTube movie rental or purchase).

How can Netflix manage to create a unique proposition for itself from this pricing model?

Premium branding of its in-house content

By creating a separate in-house original content offering, Netflix will be able to drive high buzz in the market. Netflix’s in-house content garners great reviews from subscribers and hence they wouldn’t mind paying an extra 100 for a great show in a year.

E.g. Subscribers wouldn’t mind paying Rs 100 – 150 for watching an entire season of Dark, House of Cards etc. – It’s a bargain at this price. Netflix can successfully show value for money using this pricing model.

Continued recurring revenues

The Rs 800 per month fee deters people from paying every month, in case they don’t see themselves using Netflix’s services for month(s). However, Rs 100 – 300 won’t warrant a subscriber to stop paying even if they were to not use Netflix for months.

Controlled investment in producing in-house content

By seeing the uptake of its in-house content can help Netflix in managing production costs. Additionally, understanding what kind of users prefer what genres will provide Netflix with enough marketing muscle to update its recommendation engine and possibly look for other firms to collaborate with if they want to go that way.

Netflix can also push in-house content starring newcomers at no charge or a minimum rate to understand customer response. That way the onus will be to control production costs for content starring new actors to the least. In the future, once these stars become big, this can be further used to improve customer retention and create Netflix as a premium brand of its own.

Ability to correlate viewership with business impact

Revenues from in-house content will be directly proportional to viewership, hence there will be no need to change metrics or play around with levers to boost viewership figures. Investor confidence and market results would be purely top-line driven.

To ensure brand loyalty and premium status, Netflix can also create accessories based offering, providing in-house original content branding on say mugs, clothing etc.

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Can you think of other ways in which Netflix can change its business model to capture market value? Do let me know in the comments!

References –

1.     News about Netflix’s metric change: https://www.marketwatch.com/story/netflix-changes-its-view-on-views-which-will-boost-its-numbers-by-35-2020-01-21#:~:text=For%20Netflix%20Inc.%2C%20it%20now,viewing%20at%20least%20two%20minutes.&text=%E2%80%9CThe%20new%20metric%20is%20about,33m%20under%20the%20prior%20metric.%E2%80%9D

2.     Netflix’s content creation budget: https://observer.com/2019/10/netflix-disney-apple-amazon-hbo-max-peacock-content-budgets/

3.     Data around Netflix’s subscriber base numbers: https://www.nytimes.com/2020/04/21/business/media/netflix-q1-2020-earnings-nflx.html