Does Netflix Need a New Business Model?

Netflix disclosed it added 1.7 million net new subscribers in the second quarter of 2016 -- barely half as many as the same quarter last year and 800,000 less than it had forecast -- during its earnings call yesterday. The news sent its stock plunging nearly 16%. (See Netflix Sub Slowdown Sends Stock Spiraling).

Netflix Inc. (Nasdaq: NFLX) blamed the higher churn on "un-grandfathering" of its pricing plans. The company has maintained its original pricing for customers for the past two years, but those "grandfathered" rates are now ending.

Netflix has been a darling of Wall Street, and was the top performer on the S&P index last year. It's also perhaps the most disruptive company in the video business in decades; the only startup to take on the big six media conglomerates and win. But is its luck now running out?

Unsurprisingly, its CEO, Reed Hastings, doesn't think so. He doesn't believe Netflix has run out of runway at all, instead reiterating that Netflix will reach 60-90 million subscribers in the US and deliver "material" profitability starting in 2017.

But it's also true that Netflix's competitors are starting to gain momentum. Amazon Video is developing a sizable slate of original programming, HBO's Game of Thrones franchise is powering its subscriber growth, and others such as Starz and Showtime have also launched streaming services. For the first time, downloads of the HBO Now, Amazon Video, Hulu and Showtime apps taken together have exceeded those of Netflix apps . So even though any individual competitor is far behind, Netflix's aggregated competitors are capturing market share.

And consumers frustrated with pay-TV rate hikes who cut the cord and added Netflix are most likely to be dismayed by increasing prices. Furthermore, Netflix has been accused of having a very small library in the UK (and perhaps in other non-US markets too). Cord cutters wanting more content soon discover that the cost of multiple OTT services adds up, often faster than pay-TV. (See Growth of Netflix Competitors Could be Positive for Pay-TV Providers).

So should Netflix then explore a different approach to the market? In a previous post, I discussed the potential for creating an aggregated OTT video service, and suggested pay-TV providers would be the right segment to do it. My colleague Brian Santo had a slightly different take. While he recognized that multiple OTT providers were fracturing the market, he felt it was the OTT providers who would be best positioned to unify it. (See OTT Competitors Should Unite).

And who would be better than Netflix to lead such an initiative? It is by far the most popular OTT video service, with the largest subscriber base, the highest usage, the greatest geographic reach and the most established brand. We don't bring this up very often anymore, but it is also a company that has developed an extraordinarily effective and intuitive user interface, which was extremely important in its early days. And Netflix proved its logistical skills when it had to physically process and ship millions of DVDs, and also in its largely problem-free transition to a global video streaming provider available in 190 countries. It is also unquestionably a pioneer in content delivery and encoding technologies. (See Sandvine: Netflix Traffic Share Falls, But Still Dwarfs Rivals').

Netflix doesn't believe that its market is getting saturated, noting that its gross adds are continuing to grow. But in many markets, Netflix offers the first month's subscription for free. I would argue then gross adds are not a good measure of market saturation, because willingness to pay is a determinant of effective demand -- net adds are what counts.

The company would also point out that one tough quarter is hardly a trend, and that is more difficult to argue with. Every company has a few bumps, and sometimes it's a combination of factors that just come together. The second quarter is also notorious in the pay-TV sector because that's when lots of college students go back home, cutting their cable subscriptions before they leave for the summer. It's not clear why this would affect an OTT service, but perhaps there's a link we can't identify at the moment.

It's also important to note that the company reported earnings per share substantially higher than Wall Street's estimates, even though total revenue missed analyst expectations. It is undoubtedly handling its costs well, but moving forward creating original content will be expensive. To do it in multiple countries and languages, and cater to local sensibilities, is going to put some upward pressure on operating costs.

The company is already highlighting its relationships with pay-TV providers to soothe its shareholders, including the recently announced one with Comcast. And it is clear that sooner or later, the need to keep adding more OTT services to get hit shows will start to frustrate consumers. Now -- when the company is at its peak and has as much negotiating strength as it ever will-- could be its best chance to develop a new role as an OTT aggregator.

Netflix would probably need to create a new division to handle distribution, a sort of OTT video equivalent of local loop unbundling. Other content rights holders and video brands that have yet to develop their own OTT services could ride on this platform -- remember, it's in 190 countries, not just the US. Once the concept is proven, the company could sit down with existing players and negotiate platform deals.

Let's be clear, we're not going to see Amazon.com Inc. (Nasdaq: AMZN), Home Box Office Inc. (HBO) or British Sky Broadcasting Group plc join in, at least not at first. But we have had competitive pay-TV providers for decades, so why not multiple OTT video aggregators?

Netflix may feel re-evaluating its business model is premature at this time. But today, scores of video distribution companies are finding they can't run their business the same way anymore, and wishing they had adapted sooner. Netflix should understand this better than most: it's the reason for most of this consternation. Now it just needs to avoid being at the receiving end of disruptive change.

— Aditya Kishore, Practice Leader, Video Transformation, Telco Transformation