MBA 211.1 Amazon takes on Netflix with on- line video streaming Mrs. Bento s Box Game Theory Prof. J. Morgan 1 P age MBA 211.1
While the latest to join the bandwagon is Facebook, other competitors that are looking to expand include Amazon. This could potentially disrupt Netflix's accelerated user base growth, which is the key metric for sustaining Netflix's growth and frothy valuation [ ] Netflix's stock price fell about 20% from its peak of about $247 before recovering to around $215. It seems that investors are now getting more cautious regarding competition and Netflix's outlook. [...]. Could this be a sign that Netflix's stock is topping out in the near term? 1 1 http://community.nasdaq.com/news/2011-03/facebook- stepping- on- netflixs- toes- with- streaming- movies.aspx?storyid=62782 2 Page
1. The online streaming video market On- line streaming is fueling growth in the movie rental market, and is becoming an increasingly attractive market. While the off- line movie rental market in the U.S. has been stable at about $8 billion over the last 4 years, the on- line market has spurred a growth of 70% annually reaching $2 billion in 2010. The main reasons behind this growth: a. The technology needed is ready and barriers to entry are low, thanks to the explosion of available bandwidth and broadband penetration, the proliferation of media- enabled connected devices, the availability of online/connected TVs, and the commoditization of delivery technologies b. Consumers are welcoming the new medium, as the % of total video usage is shifting favorably towards Over- the- Top video ( OTT ) (although the predominant platform is still traditional linear TV) 2 2 Source: iconsumer, 2008-10; U.S. 13-64 year- old Internet users; DC1, DO6, and V19 3 P age
TV-based OTT users have almost tripled... OTT users 1 % of respondents... gaming consoles have gone mainstream, and are the preferred device for watching OTT content on TV Preferred device to watch OTT content on TV % of OTT users ~3x 8 3 4 5 2008 Habitual OTT users 2 24 7 15 6 17 9 09 2010 PC connected to TV Other 13 18 Internetenabled TV 11 37 Gaming console 20 DVD/DVR with internet capability Figure 1: In the US, OTT penetration of internet users has tripled, driven by proliferation of access options c. Many players in the value chain are eager to enter the market: content creators (e.g., Disney and HBO), on- line distributors (e.g., Netflix, Hulu, Google and Amazon), and cable access providers (e.g., Comcast and DIRECTV), are all trying/have entered the market in a very short time span 2. Netflix has been the most successful player so far in the OTT business Netflix was founded in 1999 offering a DVD rental mail- order service. This successful business model, which allowed Netflix to outperform classic brick- and- mortar competitors such as Blockbuster, started shifting in 2007 3, when the company added on- line streaming to its offering. So far, this business model shift has proven to be highly successful to the California- based company, as the share of subscribers who are using the online service has tripled over the last 3 years (from 22% in 2008 to 68% in 2010). 3 Source: Netflix annual and quarterly reports; Netflix website; Yahoo Finance 4 P age
The success 180 Net income, USD million Figure 2: Development of Netflix net income and subscribers base 120 60 0 22 7 1 3 67 47 49 6 7 4 Subscribers, million 83 116 161 20 2003 04 05 06 07 08 09 2010 9 12 25 20 15 10 5 0 Consumer base CAGR of 45% Revenue CAGR of 57% Stock traded at $175.70 on December 2010, >25x more than 2002 issue price (45% CAGR) Analysts 4, however, disagree on whether Netflix will be able to strive in the new market as successfully as it has done so far. On one hand, the decrease in DVD mailings will reduce tied- up capital and thereby allow Netflix to invest in additional content for its streaming offering, which so far only lists 20 thousand titles, containing mostly outdated content (T2 analyzed how many out of the most popular 120 movies were on Netflix s and Amazon s catalog in a given week, resulting in 17 for Netflix and 62 for Amazon s pay- per- view service). On the other hand, the rapid growth of the market is attracting many strong and resourceful players, forcing Netflix to quickly ramp- up its investment in on- line content under the threat that newcomers will offer wider catalogs and/or more competitive prices, thereby attracting more customers. 3. Amazon has recently started offering online streaming for free to its Prime customers Amazon, the largest multinational e- commerce company, was founded in 1994 and has been one of the strongest growing retail companies of the last 20 years. In the past few years, it has started expanding its business, first by expanding the breadth of products sold (from books, media and electronics, to auto parts and home hardware), then by moving to virtual goods (e.g. mp3 music and e- books, also with the launch of its e- book reader, the Kindle) and finally by capitalizing on its synergies to offer non- retail services (e.g., Amazon Web Services, on- line 4 Source: Morgan Keegan, Thoughts on Amazon Prime instant videos, T2 partners LLC Why we re short Netflix 5 P age
payments, credit cards). At the end of February 2011, Amazon announced the introduction of an unlimited, commercial- free, instant streaming service for its Prime members 5. Analysts interpret this move as both an offensive and a defensive strategy 6 for the following reasons: Amazon might be entering the movie streaming business with a value- priced and more compelling offering to diversify and monetize the increasingly attractive market Amazon is strengthening the value proposition of Prime to increase its customer base. Prime members spend on average 3 times more than the average customer, offsetting shipping costs and yielding profits for Amazon. Increasing the growth rate of the Prime customer base, currently at 25%, as well as holding current Prime customers, seems to have a strong positive impact on Amazon s bottom line. Therefore, enhancing the Prime value proposition can be a sound strategic move Amazon recently acquired Lovefilm (Netflix s counterpart in Europe, still using the DVD mail- order model), and may want to hedge against a future declining DVD- mailing rental market By bundling movie streaming for free with its Prime offering, rather than offering it at a cut- rate price, Amazon is following the moves Microsoft made with Internet Explorer. Many customers will become accustomed to having streaming for free, and thus will not subscribe to Netflix, depriving the firm of the revenues it needs to improve its product via content acquisition. Nevertheless, the streaming offer from Amazon is quite slim compared to Netflix s, as only 5 thousand titles are listed so far in their catalog and the Amazon, most of which are documentaries and independent movies. Moreover, Amazon s offer is only compatible with 6 5 $79/year for free, unlimited 2- day shipping, source: Amazon.com 6 Source: Caris and Company 6 P age
different platforms (e.g. PCs and Apple, but not Wii or Xbox) compared to 13 for Netflix. However, analysts are placing strong bets on Amazon, if it is willing to improve its content. 4. Game theory shows that in the short term both players will probably accommodate, but as competition becomes stiffer in the future, both players might decide to fight to increase or keep their customer base It is possible to estimate the current impact on Amazon s EBIT as a function of spending for content licensing and growth of the customer base driven directly by on- line streaming. If we assume that the Prime annual fee of $79 goes directly to offset content costs, not taking into account the additional shopping volumes of Prime vs. average users, and that current spending on content is $100 million a year, then Amazon needs circa 1.3 million customers to join Prime, who wouldn t join without the streaming offer, to break even. Content spend in USD millions Customer net adds Growth rate per year to Prime due to streaming (millions) 100 300 400 900 1,200 0% 0.0 (100) (300) (400) (900) (1,200) 25% 1.3 (1) (201) (301) (801) (1,101) 50% 2.5 98 (103) (203) (703) (1,003) 100% 5.0 295 95 (5) (505) (805) 125% 6.3 394 194 94 (406) (706) 150% 7.5 493 293 193 (308) (608) 200% 10.0 690 490 390 (110) (410) 300% 15.0 1,085 885 785 285 (15) 400% 20.0 1,480 1,280 1,180 680 380 * Current estimated growth rate Figure 3: Impact on Amazon's profit given a customer base and content spending per year 7 P age This table shows that, at the prospected growth rate, Amazon would incur in losses of $300 million if it were to increase its level of spending to the current spending level of Netflix of $400
million per year, without stealing any additional customers from Netflix. Under static market conditions, Amazon would probably have no incentive to change the status quo by increasing their on- line streaming catalog, as it would only diminish profits. In order to model a game under today s conditions we made a series of other assumptions/ simplifications: Both Netflix and Amazon have access to the same content, at the same price (this is a simplification, as Amazon has better relationship with content providers, and, given its size and advantages coming from the retail part of the business, is likely to strike better deals with content providers) Amazon has no interest in expanding to a DVD mail order model (the only overlap with Netflix would be if Netflix was to expand to Europe, where Amazon s Lovefilm is operating) EBIT impact for Amazon modeled at $79/user/yr (Prime fee) + $100/yr (as Prime customers spends 3x regular customer) we hypothesize than the $100/yr EBIT impact per Prime customer already takes into account the shipping costs that Amazon has to incur to fulfill the customer s retail orders Fighting scenario for Netflix considered at $1bn spending on content 7, as price for content is projected to increase dramatically in the near future Fighting scenario for Amazon considered matching Netflix s catalog offer The game is played only by Netflix and Amazon, no other players such as Hulu or Apple are considered for the moment Payoffs are expressed as incremental to the current situation 7 Equivalent to 28% drop on average prices for current number of subscribers (e.g., $69/year or $5.75/month for streaming- only plan) Source: Janney Capital Markets; Morgan Keegan; Netflix annual reports; Team analysis 8 Page
Under these simplified assumptions a sequential move game can be started. As the decision tree below shows, now that Amazon has decided to enter the OTT market, Netflix can choose whether to fight (i.e., increase its spending on media content or lower prices) or accommodate and remain at the current level. Once Netflix has chosen its move, Amazon can answer in a similar way, i.e. either increase its spending in terms of content or stick with the current offer. Under these conditions, the following decision tree can be drawn 8 : Game tree for near term game EBIT impact (USD mn) Amazon matches Netflix s expanded catalog - $776mm - $345mm Netflix ups catalog investment by 100% + $22mm - $250mm + $44mm - $24mm Enter on- line streaming - $552mm Amazon matches Netflix s current catalog Keep out - $240mm + $0mm + $0mm Figure 4: Decision tree for near term game Looking forward and reasoning backward both players have the same dominant strategy in choosing Accommodate, as it yields higher payoffs for both independent of the strategy of the opponent. Considering this, Netflix would allow Amazon to stay at its current level of spending and forgo $24 million of profits by accommodating, while Amazon would not choose to increase 8 Details to assumptions and calculations used to model the payoffs of the two players can be found in the appendix 9 Page
spending, as it would only have a negative impact on its profits. The assumptions to this game have to be modified though if we take into account a longer- term perspective, in which more factors should be accounted for. The competitive landscape will probably undergo several changes over the next few years, and especially for Amazon, things might look different: One of Amazon s core businesses (retailing of books) will increasingly shift from physical to digital. Amazon needs to hedge this loss in a different way, i.e. by binding its Prime customer base through convenience and being successful in shifting from physical to digital content, i.e. building up reputation as a predominant player also compared to established incumbents such as Apple As OTT 9 is rapidly growing, more and more customers are deciding in favor of one provider or the other. The more Amazon waits in being an aggressive and active player in this market and in updating its content to increase the customer base, the more prospective customers might choose a different OTT provider and hence make Prime a less effective tool in gaining new customers Content providers are expected to gain more bargaining power, as the increasing number of providers will drive prices for content upwards. Here too, the later Amazon strikes deals with content providers, the more expensive these will probably be Given this set of considerations we assumed that Amazon s Prime customer base will grow to 20 million, adding to the assumptions/simplifications we described for the near term game. In this case the decision tree looks as follows: 9 Over- the- Top video 10 P age
Game tree for longer term game EBIT impact (USD mn) Amazon matches Netflix s expanded catalog +$343mm - $1,055mm Netflix ups catalog investment by 100% + $90mm - $572mm + $180mm - $96mm Enter on- line streaming + $1,690mm Amazon matches Netflix s current catalog Keep out - $1,400mm + $0mm + $0mm Figure 5: Decision tree for longer term game Amazon has a dominant strategy (see table below) in fighting for additional customers, and, considering this, Netflix has no other choice but to fight too. This is resulting in higher incremental profits for Amazon; hence it is possible to assume that the game will develop towards this direction in the near future Netflix Accomo- date Fight Amazon Accomodate Fight $180 $1,690 ($96) ($1,400) $90 $343 ($572) ($1,055) Dominant strategy Figure 6: Expected payoff table for longer term game 11 P age
5. Other issues and considerations Amazon s Prime membership offers benefits to customers above and beyond movie streaming hence there is an additional factor besides content that should be taken into consideration when thinking about churn: when offered a similar content for the same price, prospective customers will more likely choose Amazon instead of Netflix, as it is offering more value for the same money. Additionally, given its strong financial position, Amazon does not need to make money on streaming if it can make money elsewhere by driving people to Prime (similar to the case Microsoft v. Netscape in terms of browser wars). This gives Amazon both more flexibility in terms of the pricing decision, as well as a stronger negotiating position when facing content providers (besides being already partner of some of those due to the retailing business, whereas Netflix is seen more as a threat 10 ). The demand for DVDs in the mail will persist, even as demand for streaming content rises and Netflix clearly owns this segment of the market, while Amazon doesn t appear to be interested, as it has tried DVD rentals in the past and disabled the business, and currently operates only in Europe through its Lovefilm company. Netflix has hence a chance to add value to customers through bundling, and could survive in the future with this business alone. Current stock prices however could not be maintained and it would also shift Netflix from a high growth young industry (OTT) to a mature and declining one (DVD rentals). 6. Final conclusions and recommendations From the simple game we have described above, following conclusions going forward can be drawn 10 Netflix has the right to lend or rent movies once it purchased first the DVD, diminishing profits for content providers as they are selling less copies of the same movie or show 12 Page
Amazon seems to be the player with the better positioning and should use the current momentum to increase its title catalog while licensing prices from providers are still low and the overall user base for OTT is growing fast. This could be an advantageous selling point when promoting the Prime offer to prospective customer, which seems to be one of the most profitable current tools of the online retailer Netflix can still rely on the first mover advantage (e.g. more brand recognition for online streaming/movies) and should consider either reviewing its pricing decision or invest heavily in content expansion in order to increase its customer base. Should it fail to reach a critical mass that would allow it to access more expensive (but more sought after) content, it is likely that it will be pushed out of the market by stronger players besides Amazon, such as Apple or Google The OTT market is in its very early stages and a successful business model is still to be found. Both Amazon and Netflix should closely monitor what other players are doing and be ready to adapt quickly or respond once other business models start to emerge. The attractiveness of operating a streaming only business is highly questionable in the long term. 13 P age
7. Appendix Assumptions and model for near term game ASSUMPTIONS Amazon Prime Users 5,000,000 Additional Annual Growth In Prime w/ Current Content 5.0% Amazon Prime Price/Yr. $79.00 Additional Annual Growth In Prime w/ Better Content 50.0% Netflix Users 20,000,000 Netflix Loss to Amazon w/ Current Content 250,000 Netflix Users On Streaming Only 33% Netflix Loss to Amazon w/ Better Content 2,500,000 Streaming Only Plan Price/Mo. $7.99 Value of Prime Customer over Normal Customer ($/Yr) $100.00 Netflix 2012 Streaming Content Cost $1,000,000,000 Reduction in Switching to Amzn if Nflx Lower Price/Improve Content 50% Netflix Price Reduction ($/month) $1.00 Assumptions and model for longer term game ASSUMPTIONS Amazon Prime Users 20,000,000 Additional Annual Growth In Prime w/ Current Content 5.0% Amazon Prime Price/Yr. $79.00 Additional Annual Growth In Prime w/ Better Content 75.0% Netflix Users 20,000,000 Netflix Loss to Amazon w/ Current Content 1,000,000 Netflix Users On Streaming Only 33% Netflix Loss to Amazon w/ Better Content 15,000,000 Streaming Only Plan Price/Mo. $7.99 Value of Prime Customer over Normal Customer ($/Yr) $100.00 Netflix 2012 Streaming Content Cost $1,000,000,000 Reduction in Switching to Amzn if Nflx Lower Price/Improve Content 50% Netflix Price Reduction ($/month) $2.24 14 P age