The New Reality of Netflix

There have been a ton of comments online about the Netflix price changes. Many of these comments are along the lines of “the postage costs are hurting Netflix”. I’m going to take a different view and point more at the streaming business. We’ll break this into two sections, delivery costs and content acquisition costs.

Netflix DVD by Mail Business Delivery Costs

Netflix runs a profitable business renting DVDs by mail, largely because they know their maximum exposure is metered by the speed of the postal service and their own turnaround time (which they will adjust if you’re getting too many discs). Netflix is totally in control of this maximum exposure.

If you’re on the one-disc-at-a-time plan you pretty much max out at 8 discs a month, and you really need to work at it to get that many. Furthermore, whenever I get near 8/month going, “the post office” always manages to take a few extra days to make a return so I end up with 7 that month. I imagine Netflix breaks even or loses a little money with one-at-a-time customers who turn 8 discs a month. I also imagine fewer than 5% of Netflix one-disc-at-a-time customers come anywhere near 8 discs a month.

Netflix Streaming Business Delivery Costs

First of all, we need to understand that Netflix does not stream anything itself. It hires 3rd party companies called content delivery networks (CDNs) to do the streaming. Akamai and Level 3 are example of some of the CDNs Netflix works with. CDNs don’t charge a flat rate per user, they charge for traffic through their network. There are some price breaks as the volume increases, but basically the graph is linear. CDNs have huge capital infrastructure and bandwidth expenses and are not cheap at scale.

With unlimited streaming, Netflix’s maximum exposure is not in its control. Netflix modeled its streaming business based on a volume of usage it experienced in the DVD rental business. For a long time, that model worked well. Streaming usage was light, expenses were under control. But streaming has taken off. People are streaming much more than Netflix expected, and unlike in the DVD rental business, there’s no way for Netflix to meter the usage on its side to control its maximum exposure. If I want to stream Netflix 24/7, I can, and I’m going to eat up the portion of my subscription fee allocated to content delivery in CDN costs pretty fast if I do.

But content delivery is not the only expense 

Content Acquisition

Netflix is one of the largest buyers of DVDs in the world. This gives it enormous leverage in negotiating prices for content. The content owners it is negotiating with to buy massive quantities of DVDs at really high margins are the same people who own the streaming rights to the content.

One of the reasons you see so much crap on Netflix Streaming is that the studios throw in the shitty movies and failed TV shows for cheap (or maybe even free) because Netflix is such a good customer buying DVDs (which are quite profitable). This is also why you see the SAME shitty movies and failed TV shows on Amazon VOD; Amazon also buys a boatload of DVDs.

So streaming is taking off and people are loving the convenience, but they think the programming sucks. Now Netflix is discovering that the good TV shows and recent movies are not just free add-ons that the studios are willing to throw in to sweeten an order of 1,500,000 Dark Knight DVDs. What happens when Netflix wants to buy fewer DVDs because more of its customers are streaming? It LOSES leverage in streaming negotiations. WB is not going to throw in as many old movies and TV shows for free if Netflix only wants to order 250,000 Dark Knight DVDs.

Netflix is also competing against a different set of players -- it is suddenly bidding against companies like HBO. HBO is owned by Time Warner. Time Warner also owns New Line Cinema and Warner Brothers. So when the negotiations for the Harry Potter 1-7 streaming rights happens, who wins? Netflix or HBO (and their HBO Go streaming service)?

Finally, the structure of streaming rights is very different than physical rentals. The laws regarding rentals of physical media are well defined and quite mature. That all got hashed out in the VCR revolution in the 1980s. Once Netflix owns a disc, it can rent it out for as long as the DVD physically lasts without paying the content owner any more money. With streaming rights, the studio wants to get paid every time the movie is streamed.

So what is going to happen here?

There are a lot of possibilities. The CDNs are going to make a fortune. As the content gets better, unlimited streaming is not going to last at a reasonable price. Netflix is going to work hard to be able to control its maximum exposure.  Until it does, look for prices to keep on rising.

Erik Schwartz