Why you should care

Because you once thought that Blockbuster was the greatest thing to hit home entertainment since the remote control, too.

The comedian Steven Wright once quipped: “When everything is coming your way, you’re in the wrong lane.”

Lately, everything seems to be going Netflix’s way. Shares in the entertainment giant have risen 300 percent this year, making the company among the S&P 500’s top performers. It now has more subscribers than HBO — 31 million in the United States alone. Netflix is garnering respect for its much-improved personalized experience for customers, dedicated customer service team and its original content, including House of Cards and a newly announced venture with Disney’s Marvel. And with revenues topping $1.1 billion in Quarter 3 this year, all signs point in the right direction.

As a consumer who takes advantage of its streaming model for free, I think Netflix’s strategy is worth examining more closely.

But could Netflix be in the wrong lane? After all, AOL, MySpace and Nokia are not such distant memories in the Valley. And, as Blockbuster’s recent decision to close its remaining U.S. stores reminds us, the fate of even a seemingly invincible corporate juggernaut can be sealed almost as fast as you can say “consumer demand is clearly moving to digital distribution of video entertainment.”

While most observers consider Netflix fully rehabilitated after its near-disastrous 2011 decision to split the company’s streaming and DVD rental services, Netflix’s real woes could still be to come. As a consumer who takes advantage of its streaming model for free – like many others I know — I think Netflix’s strategy is worth examining more closely.

Asian woman watching her laptop on the couch

Source Corbis

The company’s first challenge is its pricing model. CEO Reed Hastings’s 2011 attempt to split the company’s mature DVD rental business and its immature but fast growing online streaming operation was not long-lived, but its impact can still be felt. (The plan, if you recall, would have forced customers to pay $8 for each service, or $16 for both, instead of $10 — a 60 percent price hike.) More than 800,000 Netflix subscribers jumped ship, and many of those who remained barraged the company with complaints. Its stock price plunged.

Back then, Mr. Hastings admitted to “messing up.” But Dan Ariely, a leading behavioral economist, says the deeper problem lies in something called an “anchored price.” When customers purchase a product at a certain price, that price becomes “anchored.” In other words, Netflix is now stuck with its price of $7.99 a month, and a customer base that might resist any future changes more vehemently than others. Spokesperson Jonathan Friedland says Netflix is not stuck, noting the company raised its subscription price in Brazil this year. Still, “right now, $7.99 is working very well for us,” he says.

Netflix is now stuck with its price of $7.99 a month, and a customer base that might resist any future changes.

Recently Netflix offered a basic tiered pricing model to increase revenue, but it’s limited. Most customers have used it as an opportunity to encourage friends and family to share the product for free.

The second weakness is Netflix content. Most of offerings are available to competitors, making Netflix struggle to stand out.

2 female prisoners right of frame in cafeteria looking towards left wearing orange suits.

Orange Is The New Black

To be sure, Orange Is The New Black was all the rave this fall, House of Cards was a huge hit last summer, and now the company is making a big bet on Disney and other original content including films. (Netflix just acquired The Square, a documentary set to be an Oscar contender this year). These offerings are good, especially Marvel, which will bring in a new audience. If Netflix continues to enjoy exclusive rights to shows that aren’t available anywhere else, this will begin to add up.

But a long road lies ahead.

Netflix’s embrace of the “binge-watching” model has been largely applauded, but one consequence is that there is not enough “buzz” around original content. HBO and Showtime on the other hand have succeeded in creating enthralling shows, with huge fan followings and enormous anticipation every week for new episodes. Homeland, Game of Thrones, Dexter, Girls and The Sopranos just to name a few.

Netflix would do well to create more hype and anticipation around its content. Withholding new content or creating enhanced profiles with the latest and greatest to increase addictiveness and to encourage word of mouth would better align with the model that has served the entertainment industry so well for decades. It would also create a new revenue stream. Perhaps the company could even offer particular genres, a certain number or even a higher quality selection of TV shows and movies depending on how much customers are willing to pay.

Instead, Netflix is in effect giving away its quality content for free. There is no distinction between watching family favorites like Love Actually versus Emmy-award-winning original series House of Cards. All are part of the $7.99 package and available at any time.

Original content could be a game changer – but it’s an expensive gamble. According to The Atlantic Wire, Netflix is spending $100 million to produce two 13-episode seasons of House of Cards, which means it needs “520,834 people to sign up for a $7.99 subscription for two years to break even.” This doesn’t include the more than $5 billion Netflix owes content makers and distributors, like Disney and Epix, for streaming rights to their movies and TV shows.

Netflix’s content licensing costs, meanwhile, have skyrocketed over the past few years. Longtime Netflix naysayer Michael Pachter, of Wedbush Securities, believes that rising content costs could scuttle Netflix’s chances for broad growth and profits. Rising content costs were one reason that an industry analyst from Jefferies & Co cited for disputing its stock price: “We find it difficult to justify this valuation given the risks of rising content costs, heavy competition, and the likelihood NFLX may need to raise additional capital to fund operation.”

Netflix’s Friedland, however, says that the company’s content licensing costs have risen alongside high growth in its subscriber base, which has about doubled over the past couple of years. “Of course the content costs have gone up, because the business is growing.”

But it’s not clear whether Netflix’s subscription revenue is growing as fast as its content costs. Original content is pricey to produce, and Netflix is now spending more to have shows of its own. Meanwhile, it may have limited room to raise subscription prices; from where we stand, Hastings seems chastened by the near disastrous 2011 pricing decision. To this day, Netflix’s customers control the relationship.

Netflix benefited from being the first mover in the DVD revolution. It was also an innovator in online streaming. But as the industry expert Matthew Ball wrote, “the period of hyper-growth and high multiples is coming to a close, and like other maturing businesses, its focus is moving towards churn management and optimization.”

Netflix played a part in Blockbuster’s demise, and Hastings will have this episode in mind as the next phase of the digital revolution begins. Like Blockbuster, he won’t want to be caught in the wrong lane.

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