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Lessons from the Strategy Crisis at Netflix

Ken Favaro

Ken Favaro is a contributing editor of strategy+business and the lead principal of act2, which provides independent counsel to executive leaders, teams, and boards.

 

Netflix would seem to be on a roll. The world’s largest online entertainment distribution business has seen its streaming revenues grow from US$1.2 billion in 2007 to $6.8 billion today. In 2015, its stock price increased more than 130 percent. More than 80 million people worldwide subscribe to its service. And in January 2016, the company announced that it had expanded to provide service in more than 130 countries. Moreover, Netflix’s original programming, such as House of Cards and Orange Is the New Black, has become hugely popular and has received critical acclaim. Earlier this spring, founder Reed Hastings told the New York Times Magazine that Netflix was enjoying a “period of stability” — that now it knew exactly where it was going. “Our challenges are execution challenges,” he said.

In reality, however, Netflix is facing an existential strategy crisis much like the one it faced in 2007–10, when its original DVD rental business became obsolete. To be sure, Netflix is the leader of the next big thing in distributing entertainment. Just as broadcasting beat radio in the 1940s and ’50s and as cable defeated broadcasting in the 1970s and ’80s, streaming now looks poised to dominate both. Cable providers have lost several million subscribers in the last five years. Total U.S. TV viewing time fell 3 percent in 2015, with half of that decline directly attributable to Netflix and viewers’ binge-watching habits. If streaming is winning and if Netflix is the most likely winner in streaming, shouldn’t Netflix be a reliable profit generator sometime in the future, as ABC, NBC, and CBS are today in broadcast TV and Comcast is in cable? The stock price says yes. But without a big strategy change, the answer is more likely no.

The broadcast and cable businesses have enormous scale economies that produced profitable oligopolies. This is because only so many companies can build the network of local TV stations required by a national broadcaster, and very few companies can lay enough cable to operate as a countrywide cable operator. Thus a handful of broadcast networks and cable companies are all that’s left standing after years of inevitable consolidation. This gives the few remaining winners huge clout with their customers and suppliers, and makes it possible for them to charge consumers and advertisers high prices for their services relative to their cost of licensing and producing their own movies and TV shows. The high profitability of their business models is a direct result of the market power they have gained by exploiting economies of scale.

The streaming business, however, has relatively few scale economies. Yes, Netflix created its own content-delivery network, with servers in more than 1,000 locations. But that kind of investment is peanuts compared to building a network of local TV stations or laying down miles and miles of cable. And yes, as the Netflix subscriber base grows, the “personalization” algorithms that power its recommendations engine become ever more sophisticated. But there isn’t much evidence that consumers will ever be willing to pay a premium for such a feature. Thus there is little reason to believe that the proliferation of new streaming entrants — including some very deep-pocketed ones, such as Hulu and Amazon — will be followed by a period of extreme consolidation, as was the case in broadcasting and cable. In fact, dominant scale could become a negative if governments around the world become too frustrated with a single Internet service hogging their country's bandwidth. (For example, Netflix currently represents a third of Internet traffic in the U.S.)

Instead, the streaming business is more likely to develop into something that looks a lot like the highly fragmented magazine sector, in which no one dominates and very few now make good money. Without the consolidation that true scale economies inevitably produce, streaming services will need powerfully differentiated value propositions to gain the pricing clout with consumers and purchasing power with content producers to sustain oligopoly-style profits. It’s not a good sign that a recent monthly rate increase from $8 to $10 was enough for Netflix to lose subscribers and add new ones at a slower rate.

The streaming business is more likely to develop into something that looks a lot like the highly fragmented magazine sector.

One solution might be for streaming providers to produce their own content, which is exactly what they have been doing, with some impressive artistic acclaim, if not yet demonstrable financial success. But if creating content is what’s required for Netflix to make big profits, it means having a very different answer to the most fundamental question of strategy: “What business should we be in?” Instead of answering, “We are a global online content distributor with some production capability,” Netflix’s response becomes, “We are a content producer with a global online distribution capability.” For the reasons cited above, the former strategy will not be a reliable profit generator in the future. And for the latter strategy to work, Netflix will need to build, buy, or borrow superior production capabilities.

This, therefore, is Netflix’s existential strategy crisis: It needs to find a value proposition that’s strong enough to win a dominant market share with a high-enough subscription rate — or a new, more economically compelling answer to “What business should we be in?” In either case, it will have to add new capabilities, either to deliver a more differentiated value proposition in its current business (online content distribution) or to prevail in a different kind of business altogether (such as content production). Without another wrenching pivot, like the one from DVD rentals to online streaming, Netflix’s profitability will never live up to its stock value.

The lesson for strategists is that you can never take for granted the most fundamental strategy questions: “What business should you be in?” “What should be your value proposition?” And “What capabilities do you need to win in your business and deliver your value proposition?” Answering these questions is never as easy as it seems, and the answers never last as long as you think or hope.

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Lessons from the Strategy Crisis at Netflix