Netflix Has A Growth Problem
Advertising and cloud gaming are unlikely to fix it.
Desperate times call for desperate measures. That’s what Reed Hastings, CEO of Netflix, must’ve thought during the Q2 2022 earnings call on July 19th. The streaming titan has been succumbing to the pressures of capital markets this year, as echoes of a recession loom on the horizon. And although the trend is common across tech businesses, Netflix has got the worst end of the stick, having lost 63% of market value year to date. Despite reporting a 1m loss in net subscribers in the latest earnings, the video-streaming business has been steadily growing this year, albeit at single rather than the usual double-digits. A drop in users is a reflection of wider trends as the industry shed almost 30 million subscribers in Q1'22, 12% higher than any other quarter in history.
For years, it has dominated the highly competitive subscription video on demand (SVOD) space with a sensible strategy. It’s focus on spending lavishly on original content, scaling in the untapped Asian and Latin American markets, and discrete price hikes in the more mature North American and European markets, with an eye on cloud gaming, have all pushed its value up. And although its subscription prices are some of the highest in the market, the business still has the lowest churn rate in the industry, estimated at around 3.5%. Investors prized that.
Following a poor quarter, the second in a row, the Californian business dreams to restore its respected status in public markets by turning their eye to advertising. But that could backfire. Advertising will be a challenging puzzle to crack for a number of reasons. For starters, recent earnings by Big Tech suggest digital advertising is slowing down. Meta reported a 1% decline in revenue for the first time. Alphabet disclosed a meagre 13% growth, compared to 62% in the same period last year. Twitter and Snap reported poor earnings too. All of this points to the business cycle catching up with the tech advertising overlords. It’s hard to see Netflix win in such conditions. When marketing budgets get cut, advertisers stick to what they know well. Additionally, digital advertising is an oligopoly. Big Tech control two-thirds of the market. Meta and Alphabet take about a quarter each, with the remainder going to Alibaba, Amazon and Tencent. Tik Tok is quickly stealing advertising revenue on the video sub-segment too. The aggressive nature of the space means more dollars — across software, infrastructure and hiring — will need to be spent for every dollar of advertising revenue compared to peers. Incumbents have achieved luxurious returns in large part due to their ability to capture and mine data from their ecosystems, to translate that into targeted ads for users. Netflix on the other hand can only access sophisticated data by purchasing it from the gatekeepers of the industry. That puts them at a disadvantage against the likes of Amazon, who would be better positioned for targeted ads on their Prime Video service. Ad-supported streaming subscriptions are also growing by 117% YoY in the US, their largest market, despite only five services in the category offering the service. Growth can sound promising, but an ad-supported plan would cannibalise on Netflix’s own regular subscriptions, which would likely lower the average revenue per subscriber. If they somehow manage to gain traction, other big players Disney and Amazon would likely jump on the opportunity, stalling their growth again.
The question also remains on whether consumers are willing to pay for a subscription and still get blasted with ads. In 2020, over 50% of US and EU consumers indicated their acceptance towards viewing ads in exchange for free content. The percentage would likely be lower if a fee is charged. But the business model has been proven to work. Five major competitors in the US offer ad-supported services for a monthly fee. For three of them, these tiers make up the highest share of subscriptions. For Discovery+, where 56% of consumers pay for the regular plan, the price difference between ad-supported and ad-free is +$2 per month, compared to at least+$5 per month for Paramount+, Peacock, and Hulu, which indicates consumers are sensitive to prices when deciding between different options. Netflix would need to price their ad-supported plans highly to avoid cannibalising on their more expensive ad-free tiers. But that could struggle to bring in the desired volume, and therefore growth.
Head in the clouds
Over the past year, Netflix has also looked towards cloud gaming to advance its future ambitions. Here too, its hopes will be squashed. It faces stiff competition from its advertising partner Microsoft, which has aspirations of its own to crack the $200bn gaming market. The Seattle giant already has a critical head start with 10 million users across 26 countries paying for Xbox Cloud Gaming. Its recent acquisition of Activision Blizzard will add video game development and publishing capabilities, along with various successful franchises like Call Of Duty, World Of Warcraft, and Candy Crush to its portfolio. That, combined with strong technical capabilities will guarantee its strong hold of the market. Other major players want a slice of the pie too. Sony has achieved over 3 million subscribers on PS Now, and boasts world-leading hardware, software and game development capabilities too. Despite being mostly known for hardware, the Japanese firm has managed to pull off a proficient cloud gaming offering. It’s $380m acquisition of Gaikai in 2012 — which provides cloud gaming technology as a service — has allowed it to stay at the forefront. Netflix should take notes. Developing the technical infrastructure for a cloud service is beyond their strengths. Unlike movies, video games need a solid connection. A one second delay in the gameplay ruins the user’s experience. With thousands playing at the same time across geographies and consoles, managing the data flow can get challenging very quickly. Matchmaking algorithms, live chats, and anti-hacking systems would add further complexity to an already steep hill.
Beyond competition and technology, there’s cash. Gaming is an expensive industry. Incumbents have earned their right to play by spending generously on content creation. Electronic Arts, a top performer, splashed $2.2bn R&D in 2021. That has yielded them some of the largest gaming franchises in the world (Tetris, Fifa, The Sims). Netflix certainly has that kind of money. It invested almost eight times that amount on original video content last year. But diverting some of that cash into games can give bigger spenders Disney and Comcast an edge in video streaming. And those funds would struggle to see returns given the competitive nature of the gaming market. The final hurdle is sales channels. Almost a third of Netflix viewers in the US watch movies on a smart TV. Computers are the second most popular device. But most money in gaming is on mobile devices. Revenues from smartphones make up over 50% of the market, and are the fastest growing segment. To see sufficient engagement, the streaming business would need to push its user base to use their iPhones and Androids more. That seems unlikely.
Netflix faces some laborious years ahead. Its subscriber growth will decelerate in the short-term due to current economic conditions. Its challenged by big fish with unlimited pools of money and resources who want a piece of its pie. And its long-term bets in advertising and cloud gaming point towards a disaster. But regardless of a disappointing performance these past two quarters, investors shouldn’t underestimate Netflix’s ability to turn a disadvantaged position into its favour. They’ve done it before. The mail-order retailer turned streaming giant defied odds over a decade ago when it launched its internet service, dismantling at-the-time media leader Blockbuster along the way. That single handedly changed how millions watch TV today. For all its struggles, Netflix certainly knows how to play the business game.
Read my other stories below
The Most Important Tech Company That You’ve Never Heard Of
How an unknown Dutch company gained significant influence over the global electronics supply chain