Will Online Streaming Work Out for Netflix?

Once defined by the red envelopes used to deliver DVDs for its mail order service, Netflix has turned its focus toward allowing subscribers to stream movies and other programming directly to their computers and television sets. The move has reaped rewards including an increasing customer base, but created friction with the entertainment and technology companies Netflix competes with — and, in many cases, relies on for gaining access to content. Wharton marketing professors Peter Fader and Raghuram Iyengar and operations and information management professor Kartik Hosanagar recently sat down to talk with Knowledge@Wharton about what the future may hold for Netflix.

An edited transcript of the conversation follows.

Knowledge@Wharton: We’re here with Wharton professors Kartik Hosanagar, Raghuram Iyengar, and Peter Fader, to talk about Netflix’s evolving business model. The first question I’d like to ask is, as Netflix expands from primarily being a mail-order DVD rental service to being a service that focuses on online streaming of movies and television programs, what are the potential positives and negatives for the company? Peter, why don’t you start?

Peter Fader: I think it’s a move that Netflix has been preparing for, for a long, long time. Even though they started with mail order, their name is Netflix. So, they have been thinking about it. They have been developing the infrastructure. Their brand isn’t necessarily tied to any one channel of distribution. They are in a really good position, as shown by their current performance. I don’t see anything on the horizon that suggests it’s going to be any different. Whether they will go on to dominate the sector, as some people are starting to fear — I’m not sure about that. But I think it’s a really good outlook for them.

Knowledge@Wharton: Would either of you like to add anything?

Kartik Hosanagar: I think [online streaming is] a huge opportunity for Netflix. Netflix spends, I think it’s somewhere close to half a billion dollars on the actual physical distribution business, which is the postage, mailing the DVDs out, and so on. Just getting rid of that over time, with more and more of the distribution happening online, changes the cost structure for Netflix dramatically, and it allows them to offer the service at a price point that would be more attractive to consumers. I think this will also allow Netflix to grow because the lower cost structure results in lower prices, and in turn brings in new customers. So, I think there are a lot of positives.

If you were to pick one negative, I think there is the potential for cannibalizing Netflix’s high-end service. I can imagine why some of the subscribers to Netflix’s premium service might actually shift to the online only, or the streaming service. And that might cannibalize some revenues. But I’d say, all in all, I see more positives from Netflix from this.

Knowledge@Wharton: Raghu, do you have anything to add?

Raghuram Iyengar: I agree with both Pete and Kartik. I think there are positives right now, but I think there are also some challenges that have come about. I think particularly if you start looking at the portfolio that they have — the portfolio of options that they have for streaming versus DVD — currently they have lots of DVD rental [options], and the inventory itself is huge because they have lots of alliances with different studios. I think they have to start rethinking about what kinds of agreements they would come to [with the studios]. For example, they have been spending a lot more money getting the streaming content, but they still have a long way to go. So, if you look at the inventory that they have for streaming, it’s much older movies and much older [television programs]. That’s something they clearly have to think about.

Knowledge@Wharton: How does the emergence of Netflix, particularly the increased emphasis on its streaming service, impact other content distribution models, such as sales of DVDs and cable television? Kartik, why don’t you start?

Hosanagar: A lot of the content deals still need to be negotiated, as Netflix moves from the DVD model to the streaming model. The way it structures these deals with the content owners [is] not yet very clear. It really depends on what Netflix is willing to offer for the content, and how early it’s able to get the content. To the extent that Netflix’s big plan works out — that it’s able to get the content early and at the right price point — there’s no doubt this will hurt DVD sales. But I would say that the content owners have several reasons to be wary about this service because of the likelihood that it could cannibalize other revenue streams for them….

Fader: I would say that the fate for the content owners and creators is in their own hands. To the extent that they just continue to produce basically commoditized content that could work equally well on any of these distribution platforms, then they’re doomed. But if they can come up with ways of adding value, to make it a different experience for someone to stream, [such as getting] the “blooper version” [of a program] only if you’re a registered member on the website and giving people reasons to buy the boxed DVD set [because it is] going to have extra value in it — I think there’s an incredible opportunity to be using each one of these platforms to promote the content consumption and purchase through these other platforms.

There aren’t a lot of good indications yet that they have the business savvy to do that. There are a few happy stories here and there, but there are an equal number of bad stories, where they are just basically creating cannibalization instead of avoiding it.

Iyengar: I think there is a lot of tension right now…. Netflix is in the middle of lots of different kinds of industries. One is, of course, the content industry that we talked about. The other is, in some sense, the cable industry, [with] Comcast being the leader there. And the third one, in fact, is … the content delivery network industry. Netflix, by being part of all of these different industries and especially moving towards the streaming set-up, is making ripples across all three [sectors]…. Think about some of the deals that Netflix has recently done, for example, the deals that it did with Starz [to stream the cable network’s movies, which include Disney and Sony films], for example. Disney is now putting pressure on Starz such that it will charge [Netflix] more [once the current deal expires]…. And Netflix is apparently trying to get new TV episodes, at almost $100,000 per episode. I think all of these things completely change the way these content developers have to think about how to add value in their own ways of getting to the consumer, as opposed to getting [to them] through Netflix.

Hosanagar: If I may react to what Peter and Ragu said, I completely agree with you guys that there is a big opportunity here, and that one needs to look at the full value chain, all these other companies, and the opportunities for content owners to package the content differently for different media. But I think the other issue is that there are all these players that have over several decades established a position in this industry…. History doesn’t suggest that these companies are vertically innovative and willing to change their business models overnight. I think that many of them, the Comcasts of the world and the Time Warners, will try to hold onto the old models. And I think that’s why I said it’s not clear. But I agree with you, that if they see that the future really is in this, that the future really is about interactive media and video on demand, and so on, then they could perhaps make significant strides….

Fader: I’ll just respond by saying, it’s true that the well-established players have more to lose. But they’ve been a little bit more progressive than their counterparts in, say, the music industry [by introducing] initiatives like Hulu and TV Everywhere. There are a lot of different kinds of experiments going on, and in many ways, it’s just different business models around the existing old-fashioned content. But at least they’re thinking about it, at least they’re trying it. The winners will be based on who has the best business models, as opposed to who has the best lawyers.

Hosanagar: Yes, I’ll give them credit over the music companies any day.

Knowledge@Wharton: We’ve seen one example of how the traditional content distributors are responding to the whole Netflix-Comcast battle of recent weeks, in which Comcast has been demanding that a company that’s been acting as a middleman pay exorbitant fees to deliver Netflix content to Comcast subscribers. What do you make of that? Is that the way cable companies should be reacting? And if not, what would be a more productive way to deal with this? Raghu, why don’t you start?

Iyengar: If you look at some of the numbers — Netflix streaming accounts for about 20% of Internet traffic from 8 p.m. to 10 p.m. at night. That is a huge chunk of data that’s being transferred….. The jury is still out on whether Comcast versus Level Three, which is the intermediary [company] — whether Comcast is in fact acting according to the agreements that they had, or do they really have to rethink the agreement…. One thing that is immediately clear is that they should resolve this agreement really soon, because the end consumers are the ones who will be hurt. This in turn has a ripple effect on how Netflix will change its prices, if there is some disagreement there.

Knowledge@Wharton: Kartik?

Hosanagar: I think that the Level Three-Comcast issue is a particularly complicated one, because Level Three has this dual role as a backbone provider and as a content delivery network. On the one hand, Level Three is justified in saying that Comcast is asking for more money because Level Three carries Netflix traffic, and this is anti-competitive. But on the other hand, it’s fairly standard that in peering arrangements, if you are exchanging an equal amount of traffic in both directions, there are no payments. But if it is disproportionately in one direction, then payments are indeed made. And so, that’s not unusual. Comcast’s response is that we are not charging specifically for the Netflix traffic, and therefore this is not a violation of net neutrality — we’re just saying that there’s disparity in the traffic going in different directions, and we’re asking for money for that.

As far as the legal side of it goes, it’s somewhat complicated because of Level Three’s dual role. But setting the legal side aside, I personally feel that, independent of what Comcast says, this ultimately is about Netflix, and about the fact that Netflix poses a threat to Comcast’s video-on-demand initiatives.

Knowledge@Wharton: Peter, do you have anything to add?

Fader: This is just one of many ways that Comcast is going to get itself in trouble. Their sheer size, the number of different businesses they’re in — talk about cannibalization. They’re a company that’s going to be cannibalizing itself in so many different ways. It’s not clear that they have thought through all of these potential conflicts. We’re going to be seeing these kinds of issues coming up time and time again and this time it involves Netflix. It’s going to involve many other entities. And it’s going to be very important for Comcast to have a coherent strategy to deal with all these things before they start flashing up.

Knowledge@Wharton: There have been a lot of questions about how long Netflix can sustain an all-you-can-eat pricing model, in which subscribers pay a flat fee to access any of the available content. Can you talk a little bit about how sustainable that pricing model is, first of all to those who provide Netflix with content, and then also to those who receive the content, i.e., the subscribers? Peter?

Fader: I’d love to celebrate what Netflix has done on the pricing side. Many people refer to it as “the Netflix pricing model” — the fact that they own it, that it is so singularly associated with their brand, is a great credit to them for going against the grain 10 years ago and staying with it. Another big part of that is that they’re constantly changing their prices, sometimes up, sometimes down. People don’t seem to notice. People don’t seem to care. They’re into the content. They’re into the wonderful delivery mechanism and the association with the brand. People like to be seen with the red envelope. In many ways, they’ve downplayed the role of price, per se. That’s what every company aspires to do, so it doesn’t matter about price: It matters about just having the value and the association. I don’t think price matters that much and I think [Netflix] has a great deal of flexibility to get away with things.

Knowledge@Wharton: Raghu, do you have anything to add?

Iyengar: I have a little bit more of a skeptical attitude toward the pricing itself. For example, if you think about — and I’ve done some calculations — if you think about how much Netflix is typically charged for the royalty [for streaming], as opposed to just sending [by] mail, it’s about 40 cents a movie. If you take that number and now take in the streaming costs, which are about five to six cents per movie — about a 1 gig transfer — you’re thinking about 50 cents per movie. If [a customer] has an $8 [per month] plan, anybody who [streams more than] 16 movies a month is already a non-profitable customer. I’m not exactly sure how long Netflix can sustain all-you-can-eat plans. My prediction is, I think you will end up seeing plans which may be differentiated in terms of the quality of movies that you [are able to stream] — for example, being able to stream movies in digital versus the standard format. Or [Netflix could differentiate subscription levels] in terms of what kind of inventory customers have access to; for example, some people might have access to newer movies versus older ones, and so on.

Knowledge@Wharton: Kartik, we’ll turn to you for some final thoughts on that.

Hosanagar: When I look at Netflix’s pricing strategy, there are two or three different aspects to note, at least from my perspective. The first one is the kinds of content that Netflix makes available. And as Ragu was mentioning, there’s the royalty that Netflix pays. And the question is, what kind of content would you have access to? What if Netflix expands its library, goes more aggressive in acquiring content early, and getting movies soon after they’re out of the theater, and so on? The question is, if the library that Netflix has changes, then the royalty structure and the cost structure also changes. And then the question is whether Netflix can give [customers] access to everything at $7.99, or is Netflix giving you access to some portion of its library at $7.99, and then there’s some other [inventory] that is blocked? I think one question is, what is the content library that is made available? And [the current] content library might be very different from the content library they would like to have, say, five years from now.

The other thing is that lowering the price brings in a whole new set of customers to Netflix. I would expect Netflix’s customer base to grow quite dramatically with this lower price point. I think the content they have and the opportunity to go after new customers are two really important issues.

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