A subscription model is what’s helped the online streaming giant to stay true to its customers.
“It takes a lot of hard work to make something simple, to truly understand the underlying challenges and come up with elegant solutions,” Steve Jobs said. Apple’s first marketing brochure in 1977 noted, “ Simplicity is the ultimate sophistication. ” And simplicity is the design principle of the high-tech world: Google’s search homepage, Uber’s ride booking, Amazon’s 1-click ordering. “Join free for a month,” viewers were advised on the NetflixNFLX +0.4% homepage. “If you decide Netflix isn’t for you—no problem. No commitment. Cancel online anytime.”
Netflix, which was once a DVD rental provider, reported during an April 16 earnings announcement that, in the first three months of 2018, it had gained 7.41 million users, of whom 5.46 million lived outside the United States, and had a total subscriber base of 125 million users. That 125 million was the magic number that Wall Street analysts obsessed over was understandable. Netflix had said it would spend $7 to $8 billion on original content in 2018. $7.6 billion was what Pfizer spent on research and development for new drugs in 2017. “We’re investing in more marketing of new original titles to create more density of viewing and conversation around each title,” read a Netflix statement. It is believed that there will be more customers rolling in to help foot the bill.
The growth narrative still holds, judging by the surging stock price of Netflix that followed its earnings announcement. A measure of investor confidence regarding the growth prospects of a firm is the P/E ratio, which measures the company’s current share price relative to its per-share earnings. Google is sitting at around 32, Microsoft at 28, and Facebook FB +1.38% 26. By the same measure, Netflix is an outlier, with its P/E exceeding 240. In other words, investors are willing to bet nine times more on Netflix than on Facebook or Google for every dollar that any of these companies currently earns. Why is that?
Among business school academics, the “network effect” is a common refrain that explains the rise of Facebook, Google, Uber, Airbnb, and Alibaba. In each of these cases, the company took on the role of a two-sided marketplace, facilitating selling on the supply side and buying on the demand side to enable the exchange of goods or services. The value of such a platform depends, in large part, on the number of users on either side of the exchange. That is, the more that people use the same platform, the more inherently attractive it becomes—leading even more people to use it.
Because of this network effect, users are willing to pay more for access to a bigger network, and so a company’s profits improve when its user base grows. Scale begets scale. Grow fast or die. That is why Facebook is obsessed with growth. That is also why, when Snapchat went public in March 2017, the number of daily active users became the single most important metric for potential investors. The more that people hang out on Facebook or Snapchat—reading news and playing games—the more willing big brands, such as Coca-Cola, Procter & Gamble, and Nike, are to buy ads there. Once a platform reaches a certain size, it becomes too dominant to be unseated.
What this theory forgets is that a platform can also introduce the problem of conflicting interests, a moral hazard. A social media platform will always be motivated to better serve the advertisers’ interests than those of the consumers since the latter get their product free, and the platform needs money to survive. The bottomless scroll on Facebook’s newsfeed is designed as much to keep every user fixated on the tiny screen as it is to fragment her attention. Videos on Facebook average 24 seconds to 90 seconds in length. Any posts exceeding 400 characters get truncated on display. When asked if Facebook would allow people to opt out of all the platform’s data-driven advertising, Chief Operating Officer Sheryl Sandberg said it was not possible because “they would have to pay for it.” Evidently, we are not the customers of Facebook, we are mere products that Facebook is selling to advertisers.
And yet, a paying product or a subscription model is what makes Netflix valuable. CEO Reed Hastings liked to say that he founded Netflix because Blockbuster fined him a $40 late fee on his rental of Apollo 13. That was unlikely because Netflix was founded in April 1998 as a pay-per-rental provider with a late fee condition on its 925 available titles. It was in September 1999 that Netflix launched its monthly subscription concept then did away with all late penalties and hidden fees. To balance DVD availability, however, Netflix had to build a proprietary algorithm, asking customers about their preferences through a simple survey. The system would recommend movies that were appealing and immediately available. It would therefore avoid frustrating a customer by showing any selection that was currently out of stock. This inventory management system was to become the foundation for Netflix’s next strategic leap toward becoming a data-driven company in an arguably taste-based category. In October 2006, Netflix offered a $1,000,000 prize to the first developer of a video-recommendation algorithm that could beat its existing algorithm at predicting customer ratings by more than 10%. Three months later, Netflix announced that it would launch streaming video.
All of this put Netflix in a most interesting spot. Traditional television ratings are only approximations. Cable TV networks may green-light a pilot based on tradition and intuition. By contrast, Netflix’s algorithm has the advantage of knowing when and where we watch a show; knowing how we pause, rewind, or fast forward; and triangulating all our behaviors with those of other groups of viewers. In 2013, when House of Cards premiered, Netflix made headlines by releasing the 13 David Fincher-produced episodes all at once. The company already knew that a lot of users had watched Fincher’s movie, The Social Network, from beginning to end. The British version of House of Cards had been well watched. And those who had watched it had also watched other films by Fincher. So Netflix was confident enough to single-handedly invent a new consumption habit: binge-watching. The company was able to confidently predict binging behavior among thousands of viewers, who would consume the entire series in one gulp over the weekend. And they did.
Such is the new era of TV drama. With HBO, Netflix Originals, and Amazon Prime, on-demand TV is taking Hollywood-style on cinematic series. “Getting immersed in multiple episodes or even multiple series of a show over a few weeks is a new kind of escapism that is especially welcomed today,” noted cultural anthropologist, Grant McCracken. Viewers immersed in binge-watching soon forget all mundane aspects of their everyday lives, as if being carried away by a current. Once people are in the “flow,” as Mihaly Csikszentmihalyi describes, it feels spontaneous and effortless so long as they give their undivided attention to a single storyline over a sustained period of time. And exactly what are these people trying to escape? Perhaps a getaway from all the incessant noise from emails, newsfeeds, and every other political chatterbox.
What Netflix has demonstrated is an age-old formula among high-tech companies. Companies that leap toward data and algorithms can automate and augment decisions that human experts used to make based on intuition. But Netflix also departs from other tech giants in that it has created a business model that promotes sustained attention rather than fragmenting it. Its content team draws on its rich trove of customer data to produce shows that are sophisticatedly engaging and long. And this, in turn, allows Netflix to charge subscription fees in lieu of selling advertisements.
The financial market seems to appreciate this subscription model. It’s a simple story. And simplicity is the ultimate sophistication.
Originally published on Forbes.
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