Executive Summary
Netflix is a famous American video service in the world that sells Internet access to a large number of movies and TV series based on streaming media.
1997 is the year of Foundation of the company by Reed Hastings and Mark Randolph.
As the story goes, a business concept called Netflix originated in the head of one of the founders of the company Reed Hastings, after Reed received a fine of $ 40 from the video rental company because he forgot to return the DVD on time. After this incident, the founder of Netflix came up with the idea of creating a more convenient service, that sells access to movies and TV series on the Internet.
Nowadays, Netflix experiences the increasing number of viewers who subscribe to the video streaming service and watch more than 140 million hours a day. The company streams TV shows, documentaries, movies, and original production (an example is Stranger Things) to more than 120 million subscribed users per month in approximately 190 countries.
Netflix produces more programs on its own and continues to make deals with film studios and television production studios, independent producers and others for the rights to distribute their content. For viewers to continue to come back and be involved in content, Netflix deploys more complex algorithms ever to predict the preferences of the viewer and give recommendations on what to watch next. Despite DVD segment declines every year Netflix is still mailing DVDs to US customers.
Netflix's subscribers are allowed to watch as much content as they want, and it is also entitled to view it simultaneously on multiple devices with a higher subscription cost.
The Netflix's business is organized into three operating segments: domestic streaming (about 55% of revenue), international streaming (about 45% of revenue), and domestic DVD (about 5% of revenue).
Even though the company shows excellent financial results and its revenue grows quarterly, there is a threat of piracy in this industry, which «eats up» almost 50% of the revenues of companies operating in this industry.
To keep revenue growing, Netflix can not only follow offense strategy — change pricing policies and increase tariffs — but also protect its original content from piracy.
Financial Performance
Over the past 5 years, the company's revenue has grown steadily. In 2017, the revenue increased by 24.4% compared with the previous year, that is $ 2,862.04 million. It is also important to note that revenue increases quartile by quartile. The increase in revenue was mainly driven by the rise in the average number of paid streaming memberships globally, most of which were increased by Netflix's international memberships.
For the last three years, the company has been changing prices for subscription plans. In 2016, Netflix raised its standard HD plan to $9.99 per month, up from $8.99. In 2017, the company again raised the price for a standard subscription plan for $1, so the price changed from $ 9.99 to 10.99 per month. Additionally, Netflix increased prices for its premium service by $2. Now it costs $13.99, up from $11.99. The price of basic service remains the same at $7.99 per month.
Number of subscribers increased to 23,786 thousands that is 25.3% more than in 2016. In the previous period, the number of subscribers also increased by 25% compared with 2015. Extremely high percentage change in domestic and international subscriptions also influenced the rise of revenue: an increase of 21% and 58% in revenues in the Domestic streaming and International streaming segments, respectively, as compared to the year ended December 31, 2016.
Domestic DVD segment revenue decreases year over year. In 2017 it declined by 17%, in 2016 it dropped by 16%. However, even though revenue from this segment is falling along with the number of members, it is too early to think about closing the segment, since the contribution margin in this segment is extremely high and in 2017 was 55%. For comparison, contribution margins from Domestic Streaming Segment and International streaming Segment in 2017 were 37% and 4%, respectively.
The increase in the company's operating income was primarily due to an increase in revenues, partially offset by an increase in content costs, as Netflix continues to purchase, license and produce content, also including original Netflix content. This increase in content costs includes expenses of $39.1 million related to unreleased content, which Netflix decided to refuse. Staff costs to support continuous improvement in streaming service, international expansion, and increased content production expenses have also increased. The increase in net profit consisted of an increase in operating profit and an increase in tax benefits, mainly due to the adoption of the ASU 2016-09 in the first quarter of 2017.
To compare financial performance of Netflix the following companies were chosen: Amazon (Amazon Video), Time Warner Inc (HBO Now), Walt Disney Co (owns 60% of Hulu) and launches its own streaming service.
Over the past five years, the return on assets of Netflix was fluctuating. In 2015, it decreased dramatically by 2.86 points. This was due to a decline in net income in 2015. Net income decreased mostly because of increase of interest expense due to the higher aggregate principal of interest-bearing notes outstanding. Also in 2015, Netflix experienced $37.3 million foreign exchange loss, incurred in the first quarter of 2015. The foreign exchange loss was driven by the revaluation of liabilities denominated in currencies other than US dollars in the European organizations of Netflix, combined with the strengthening of the US dollar.
Return on equity was also affected by the changes in net income. In 2015, the value of ROE dropped by more than 50%. Then the generated profit for every dollar of shareholders’ equity started to rise again, and in 2017 it equaled $0.17. Compared to the prior period it increased by 10 points and almost reached the average in the industry. It is also interesting to note that for the last 12 month of operations the ROE of Netflix is the highest in the industry. It means that Netflix generates more profits with each dollar of shareholders’ equity than anyone in the industry. We also need to keep in mind that streaming segment is not the primary source of revenue of chosen competitors.
Netflix's business model may seem simple, but streaming online video is heavily burdened with costs, most of which are license fees for content and investment costs for setting up its Internet infrastructure and running online operations. Netflix's business model may look straightforward, but online video streaming is heavily laden with costs, the majority of which are content license fees and investment outlays for setting up its Internet infrastructure and running the online operations. As such, Netflix's operating margin is considerably thin, at 7.17% as of 2017. Unless Netflix has its own content, it can exert little control over how much it pays movie studios and TV networks for streaming rights. The Netflix's own new shows helped to increase its subscriber base, and production costs were distributed over a more extended period, so the company's operating margin improved.
Growth stage companies such as Netflix invest a lot of capital in their investment activities. With limited profits and cash flow from their operations, Netflix has to resort to debt to finance its various investments. As of the last year, debt to equity ratio of Netflix equaled 4.31, it means that liabilities exceed equity 4.31 times. It is important to note that the value of ratio increased year over year, and always exceeded industry average. Debt to equity ratio higher than 1 means that the Netflix is becoming more highly leveraged by debt.
For the last five years, return on invested capital of Netflix fluctuated. During the last three years it was increasing because of:
- changing in prices and subscription plans;
- increase of revenues in international and domestic streaming segments;
- in 2017, operating income increased almost two times compared to the prior period. Increase of operating income lead to rise of NOPAT, that at the same time increased value of ROIC.
Overall, Netflix shows good financial performance especially for the last 12 months of operations. The level of Netflix’s profitability reaches the results of giant companies, for which the streaming service is not the main source of revenue. This proves that today netflix is the undisputed leader in this segment.
Netflix has already started to increase the prices of some tariffs, and in the future, it can continue to do so to increase the operating margin. Even though Netflix has raised the prices of subscription plans, there are more and more customers, so people are not repulsed by the increase in the cost of the subscription. Besides, if Netflix continues to increase the price of the subscription to premium service every year for $2, it will reach the rate of cable TV connection in about ten years.
SCP analysis
Tacking into account ROIC results, large number of players in the industry, and the fact that industry of online-streaming experiences price wars of the players, it can be concluded that the structure of industry is monopolistic competition.
Structure: Monopolistic competition.
Conduct: Differentiation.
Performance: Average.
Companies differentiate each other using different subscription plans and pricing. Some of the competitors charge premium for subscriptions without adds, some of them charge premium because of technical issues. Amazon charge additional costs for movies that are not included in the prime membership, Hulu charges premium for live-TV option.
Netflix charges more as it has original content that is available only on Netflix platform.
Because of these differences between major streaming services, customers subscribe to several of them. Industry performance is average (4.5 -14% ROIC).
Porter’s Five Forces Analysis
Buyer power threat is high. The main competitors of Netflix are Amazon Prime Video, Hulu and HBO Now. All these streaming services have low switching costs. For the 13th of December the basic tariff of Hulu and Netflix is almost the same and its cost is $7.99. Premium subscription on Netflix costs $13.99, subscription without commercials on Hulu costs $11.99 per month. The price of subscription to HBO now is $14.99 per month. Amazon Prime Video is included to Prime Membership and costs $13 per month, but renting or buying of additional content will be available for additional charges. The price to sign up to service is minimal and there is no annual contract. Also, all of the services have free trial periods. It is very easy for the client to switch from one service to another. For example, after a month of using Netflix, the client can easily cancel the subscription and switch to Hulu. And in the same way he can change Hulu to HBO after some time. Moreover, customers can cancel subscription without termination fees.
Moreover, there is a threat of piracy content availability. Outside of the U.S. there are a lot of web sites with free content that can restrain revenue growth internationally.
Supplier power threat is high. Netflix partners with content providers to license streaming rights for a variety of TV shows and movies. There are several reasons why a movie is not available on Netflix: the content rights are currently exclusive to another company; the streaming rights are not available to purchase from the content provider; popularity, cost, seasonal or other localized factors, or availability.
This is to say that content providers can change the streaming platform after contract expiration. When suppliers of content terminate their relationship with the VOD platform, they decrease the amount of content that Netflix can offer its consumers.
Also, some suppliers create their streaming platforms. For example, Disney is pulling its content from Netflix and starting its streaming service. It is worth noting that this is a significant blow to Netflix because it will lose not only Marvel films, but also Disney animated films, as well as Star Wars franchise films. Thus, Disney launches the «Netflix-Killer» service, which will offer viewers extremely high-quality content.
The intensity of rivalry is high. A lot of digital streaming services as Amazon Video, Hulu, HBO Now, YouTube Red, Google Play, iTunes, PlayStation Video and other services emerged and the increasing number of digital streaming providers may be seen as increasing rivalry in the industry. According to the CNBC survey, there are three main competitors in the Video On Demand (VOD) industry: Netflix, Hulu, and Amazon. Netflix owns 51% of the market, Amazon Video has 33%, and Hulu — 14%. However, a lot of VOD users have subscriptions to multiple services. Only 17% of users use only one service, and almost 30% of users are subscribed to 5 or more services.
Barriers to new entrants are low. Nowadays, a lot of companies that are related to streaming video content are copying the business model of Netflix. Over the past year and a half, the number of streaming video services has increased dramatically, when it comes to alternatives to traditional TV streaming services now offer consumers more choices than ever before.
New features from some of the world's most significant technology and entertainment companies are available now or will be soon. Consumers can now subscribe to the new DC universe recently launched from DC Entertainment. It is expected that the new subscriber service from Walmart under the Vudu brand will debut by the end of the year.
Then in 2019, new streaming services from Disney and Apple should be available to consumers, as well as a new HBO-based service from AT&T. Amazon is also planning a new free ad-supported service in addition to Amazon Prime, but they didn’t announce when it will be available.
Substitute threat is moderate. Even though the popularity of online video content streaming is growing, there are still several substitutes on the market. These substitutes include cable TV, movie theaters, and buying or renting a DVDs. According to the CNBC survey, 56% of Americans stream, and 36% (out of that 56%) use both streaming services and cable or satellite TV. 30% of Americans use only cable or satellite TV, and 14% don’t use anything. The simultaneous increase in the popularity of digital streaming and the decline in the prevalence of traditional media reduces the threat of substitutes.
However, some users may be reluctant to adopt new ways of watching video content. Although the price of digital streaming is three times less and without the obligation of an annual subscription people who are accustomed to the traditional way of watching television and they are uncomfortable to use new technologies, most likely will not change anything and will continue to use familiar technologies.
Also, these substitutes have their advantages, which Netflix does not have. Cable and satellite TV offers live viewing of shows and sports events, and cinemas offer customers to view new movies immediately after release.
Nowadays, these substitutes do not pose a significant threat to the company, but we need to keep in mind that in today's world, technologies are developing at high speed and, perhaps, in the future, a new product could be released, which can be a threat.
VRIO Analysis
Resource | Valuable | Rare | Hard to imitate | Non-substitutable | Competitive consequence | Performance Expectation |
Variety of Compatible Devices | Yes | No | No | No | Competitive Parity | Average Returns |
Original Content Production | Yes | No | Yes | Yes | Temporary Competitive Advantage | Average / Above average returns |
Rights to stream video content | Yes | Yes | Yes | Yes | Sustained competitive advantage | Above average returns |
Netflix’s Algorithm | Yes | Yes | Yes | Yes | Sustained competitive advantage | Above average returns |
Netflix is available on almost all devices (Internet-ready TV, Apple TV, laptop, smartphone IOS and Android, Xbox 360, PlayStation 3, Blu-Ray player, Nook or any other e-tablets). Netflix is ready to supply its content wherever its customer is and whatever device he has. Netflix has the most compatibility. However, its closest competitors Hulu and Amazon also give their customers a choice on what tool to stream.
Netflix began producing its own content in 2013. In February 2013, the first series of the House of Cards made its debut. Since then Netflix shoots a lot of content, not only for American consumers but also for buyers from around the world. They create content in the language of consumers in countries such as China, South Korea, Japan, France, Spain, Mexico, Argentina, and so on.
Companies like Hulu, Amazon, and HBO also shoot their own content. HBO content was the most successful in 2016 and 2017, since the 94 and 111 TV shows, respectively, received an Emmy Award. However, in 2017, Netflix came closest to the HBO result: 91 Netflix’s TV shows received an Emmy award. This number has grown significantly from the previous year, in 2016 only 54 Netflix TV series received Emmy Award.
Netflix has the broadest selection, with thousands of titles to choose from. Netflix has licensing deals with CBS, ABC, Fox, NBC, Starz, BBC, Sony, and DreamWorks, all of which contribute to the library. Industry estimates set the Netflix selection at about 25,000 titles, the Hulu Plus selection at around 10,000, and the Amazon Prime selection at about 5,000 titles. Netflix’s library is huge and exceeds libraries of Hulu and Amazon 2,5 and 5 times respectively. Trus, Netflix has the broadest audience.
Netflix started as a web site where subscribers could order DVDs. To organize better supply system and improve distribution of not only just released movies but also not the most popular ones it invented surveys and personal ratings of subscribers. Thus, Netflix started to recommend content to its customers, based on their part ratings, that they may like.
The algorithm of Netflix makes its service unique. Now, it is a massive database that is analyzed by Netflix. Thanks to this tool, Netflix knows where to stream and what. They also use this data to produce their original content. They know what genres are popular now and where. Netflix knows what to supply.
Strategic Vision
Netflix is doing an extremely good job and it is visible that for now Netflix is a leader in the VOD industry. But, according to Digital TV Research, piracy is an important problem to solve in the video streaming industry. Pirate torrents are still remain popular. For example, Pirate Bay web service had 234.5 million visits in February 2017.
According to the graph below, by 2022, the piracy of video content will almost doubled and is projected to be $51.6 billion.
Piracy threatens not only Netflix, but the industry as a whole. To increase revenue, Netflix needs to protect its original content first. It is necessary to deal with unlicensed streaming platforms at the level of legislation. Internet piracy is most common in the United States, Russia, and Central Asia. Accordingly, the fight against piracy should begin in these regions. Fighting piracy is a long process, but it is an excellent way to increase revenue over a long period.