Netflix’s Miss, New Assumptions, and Increased Competition

It was interesting to see some of the Netflix bears come out yesterday and add comments via Twitter and other platforms. I find it more difficult to buy any of the extreme bear cases for Netflix, but it is important to recognize and understand some of their broader challenges.

Churn and Customer Acquisition Costs
Naturally, this is where most people dig into the broad analysis of Netflix. While Netflix does not release its churn number, I imagine it is lower than many think. Some reports/studies peg it lower than 10%, and others have had it at 20%. I think we can safely assume it is lower than 20% and I wouldn’t be surprised if it is quite a bit lower than that. People cite Netflix’s ease to cancel as a reason it has a higher churn. While this is true, most consumers are lazy, and I’d argue still find value in the back catalog of content, and therefore, while easy to cancel I strongly doubt many people cancel and re-subscribe only when there is an original show they want to watch.

That being said, as more of the value from Netflix shifts to original content their full season release and customer binge-watching habits certainly bring up a concern that consumers will just watch the new series in a matter of days then simply cancel their account. While possible, this was a key part of the essay I wrote called Netflix and The Future of Entertainment. What I outlined was how Netflix’s upside in original content hinged on their ability to keep creating quality stories and in essence delivering stories as a service. Netflix needs to always have something interesting and new for consumers to watch. If they can’t do this, they run the risk of a continued churn of customers who watch what they want, then cancel and re-subscribe when something new comes out that interests them.

This is a central reason why looking at the customer acquisition costs of Netflix and compare them to a cable company is not quite accurate. Cable companies spend roughly $400 to acquire a new customer. This is a mix of costs of the hardware they provide/lease to customers and marketing, but cable companies have the luxury of locking customers into long-term contracts and charging on average $80 or more. Cable companies can roughly guarantee they will make up their customer acquisition costs in less than a year and then profit for the next year of the average length of two-year contracts most customers agree to. Netflix has no luxury of a guaranteed length of subscription, and while I’m sure they analyze their churn greatly today, that number is fluid and can change quickly without warning to Netflix.

Another factor in Netflix’s customer acquisition costs to consider is the cost of original content. No one is spending more on original content than Netflix right now, and while it is difficult to estimate the combined costs of original content into customer acquisition costs, it is no doubt an analysis Netflix must do. We know from nearly every bit of research we have seen that original content is the primary factor driving new Netflix subscriptions. The bottom line with my point is there is no way Netflix is recouping their estimated $8 billion spent on original content in 2018 in new subscribers, or even with existing subscribers for that matter. Netflix’s content spend is necessary to customer retention and to drive new subscribers but results in a loss overall for the company.

Content Competition
While investors are allowing Netflix to spend $8 billion in content today, that number is not sustainable for much longer. Netflix’s initial hope, I assume, was that by spending so much on content, it would put them in a position competitively to negotiate better on original content deals much like the major TV networks who don’t spend anything close to Netflix on content. However, Netflix’s assumptions of their ability to do this likely did not account for the competition in Amazon and Apple who are also helping drive the cost of original content up due to their willingness to spend premiums and both companies having a larger cash war chest than Netflix thanks to a vast array of revenue streams to Netflix’s singular revenue stream.

For this reason, my thesis is Netflix will have to vary their business model and offer a lower-priced tier, or even a free tier and subsidize with ads. Another option for Netflix is to syndicate their original shows when they are eligible. I believe the current eligibility number is around 80 episodes when an original content holder can sell earlier seasons to other networks for syndication. While it seems unlikely Netflix wants to do this, it may be hard to pass up the money at some point in the future. Besides another obvious rate hike, Netflix may also be forced to cut-down on the number of users they allow to share a singular account. While neither a rate hike or tougher restrictions on sharing will go over well with customers, Netflix has to do something to offset slowing new subscriber growth.

Going forward, Netflix likely needs to adjust for forecast estimates as I have a hunch their overall new customer growth is likely going to slow. The real question is how long investors will be willing to be patient with Netflix’s losses in original content spending, especially in light of the growing competitive environment. For investor patience to remain entrenched, like it is with Amazon, it helps when investors believe the company has little to no real competition. Perhaps that was a belief of Netflix a few years ago, but I don’t think that is a safe assumption any longer.

I don’t expect Netflix to make an overall strategy change in 2018, but I do think something will have to give in 2019 and it will be interesting to see how Netflix responds to the changing competitive environment.

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Ben Bajarin

Ben Bajarin is a Principal Analyst and the head of primary research at Creative Strategies, Inc - An industry analysis, market intelligence and research firm located in Silicon Valley. His primary focus is consumer technology and market trend research and he is responsible for studying over 30 countries. Full Bio

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