Netflix has eye on Europe

January 31, 2011
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It was probably inevitable that Amazon would swallow Lovefilm whole eventually but the speed with which it happened surprised some observers, not least Reed Hastings, Chief Executive Officer of US rental and streaming service Netflix.

Hastings notes that Amazon used to be in the video rental business but sold its interest to Lovefilm. Now it’s bought back the whole company. “We are not sure what to make of it. It will take a couple of quarters to see what they plan to do,” he says.

Netflix announced its own impressive Q4 figures last week. It added 7.7 million subscribers in 2010, more than double the 3.6 million that Hastings predicted at this time last year.

His original forecast was so wide of the mark that he declines to say how 2011 will turn out. “The business is moving so quickly, it will grow but by how much? Part of what makes forecasting subscriber growth challenging is that we continue to improve our service, which creates a better value proposition and expands our market opportunity,” he told investors.

In spite of his reluctance to quantify future growth, Hastings and his team are pro-active in trying to improve the company’s fortunes. Earlier this month, Toshiba, Sony and Samsung were among several CE manufacturers at the 2011 International Consumer Electronics Show to reveal TV remote controls with a prominent red Netflix button. These devices offer “one-click access” to streaming content and bring still more customers into the Netflix camp.

The company’s total subscriber base in the US and Canada has risen to a shade over 20 million. The scale of this achievement becomes clear when compared to the Broadband Forum figures for Q3 2010 just released by research organisation Point Topic. France leads the pack as the most connected country in the IPTV world, with almost 10 million subscribers. China is close behind (9.1 million) and the US takes third place (6.8 million).

US telecom AT&T signed up a quarter of a million new customers in Q3 for its IPTV Video On Demand service, U-verse, and reached a total of 2.7 million households. Despite an offer of new-release titles 28 days before they are available elsewhere, AT&T is still a long way behind Netflix, which added three million subscribers in the final quarter.

Hastings reports a modest growth in DVD rentals, probably the last time this will happen. “We think the bulk of the remaining video store customers will tend to visit kiosks for $1-a-day DVDs; they will get streaming content from Netflix,” he says. “Even though we expect DVD shipments to decline this year, we want to be clear that we intend to continue to offer great DVD-by-mail service for many years to come.”

While Netflix has built its subscription streaming service, revenues for DVD kiosk rental operator Redbox in the US have continued to rise although at a much lower rate than parent company Coinstar had forecast at the start of last year. Redbox revenues for Q4 2010 were up 38% year-on-year, which equates to just $11 million more than in Q3.

This sluggish performance could be due to consumer reluctance to rent Blu-ray titles at $1.50 a day when the same titles on DVD are just $1.00. Blu-ray Discs occupy space in the kiosk that more-profitable DVD catalogue titles would otherwise take, and so reduce choice and perhaps send potential customers away to search online. Coinstar blames the 28-day window – imposed by content owners in return for access to first-release titles – for the failure of Redbox to reach its targets.

Hastings can afford to be generous when asked about the competition: “I am pretty confident that our success is not what is hurting Redbox. We are super-focused on streaming, Redbox is focused on new-release DVDs and they do a great job at what they do.”

With the US market for Netflix apparently secure, Hastings has turned his attention to the company’s first international venture, north of the border in Canada, where there has been a slight wobble after a successful start. American consumers are used to an “all you can eat” bandwidth agreement, which allows Netflix to stream video content into homes without additional charges from the ISP. A recent change in many Canadian contracts means that moderate users of Netflix can quickly exceed their monthly allowance and lead to punitive charges for the excess data.

Hastings says, “We are definitely worried about those homes that are capped and might face surcharges of one or two dollars per gigabyte.” He added that many consumers do not fully understand their plans and initially they might not notice additional charges.

“It will take a billing cycle or two for them to realise, and that is a potentially a significant negative for Netflix. The shame of it is the marginal cost to deliver a gigabyte over a wired network is extremely small – less than a penny,” he says.

Hasting is nonetheless confident that the problems in Canada can be resolved, but he is cagey about where Netflix will head next. He told investors: “We will expand into an additional market in the second half of this year,” and said that the best use of its dollars will be to build a business in a country that is likely to be a sustainable source of profit. “We target each specific territory to achieve a positive operating margin within two years of launch. In Canada we expect to achieve that in less than a year,” he said.

A range of factors will influence the choice of where Netflix will invest next. Hastings says: “It is a mixture of how competitive it is, how good the broadband is, what content rights you can get, the economic growth rate, what are the levels of piracy. Wherever we go next, it is just one building block. Our hope is to go country by country and expand quite rapidly in 2012 and 2013.”

If that expansion proves to be in Europe, Netflix will be head-to-head with Amazon and its newly acquired streaming video partner, Lovefilm. The rumour machine has announced the imminent arrival of Netflix in the UK on several occasions over the past year but it is not yet certain where the streaming video service will come to land. Lovefilm also operates in Germany, Norway and Sweden and any of these countries would meet the stringent requirements of the Netflix CEO. “Typically, in the markets that are the biggest prize there is already vigorous competition,” says Hastings.

He believes that most content will be eventually available to any IPTV, cable or open internet operator that can afford to pay the going price. “We could compete on an exclusive basis, we are willing to do that if we have to, but we think it makes more economic sense to share windows,” he says, “Conceptually, you each pay two-thirds and the studio then gets one and a third of what they get now. We try to make the content owners more money with deals like that and allow other aggregators to pay a little less.”

There will be no bandwidth barrier to streaming video across the Atlantic when Netflix does eventually arrive in the old world. “We calculate that a single fibre optic cable, the thickness of a human hair, can carry 100% of the total Netflix traffic and that fibre optic capacity will increase over the next three years. The rate of innovation is greatly outstripping any growth that we might achieve,” says Hastings.

When Netflix confirms its next international destination, it is likely that a European “data warehouse” will store and forward content to customers. Over the past year, the company has reduced operating costs by switching from warehousing its own digits to using AWS, a third party data centre. “This is part of why we’ll have minimal capital expenditure for IT,” explains Netflix CFO David Wells.

Ironically, AWS is the acronym for Amazon Web Services, owned by the same company that now also controls Lovefilm, the most successful potential competitor for Netflix in Europe. Wells says, “AWS has given us multiple assurances that they want us as a strong reference customer independent of how much or little the retail side of Amazon eventually competes with Netflix.”

It appears that Amazon has negotiated itself into the perfect position: if either Lovefilm or Netflix should win the battle for streaming video subscribers, Amazon could take the prize.

Virgin Media and BSkyB, however, are not likely to give in without a fight – both have strong connections with content owners in the entertainment industry – and other services might yet deliver a credible alternative.

Hastings has a clear view of where he plans to take the company in the future and he compares Netflix with the arrival of Fox 20 years ago. He says, “Every new entrant bids up the price of content and the incumbent aggregators are not pleased. Netflix is good for consumers, good for content producers, and is one more competitor for existing aggregators.”

In an expanding market, something as simple as who has the remote control could be the deciding factor: Netflix has already secured a place for its button.