January 17, 2017

Case Study: Netflix and Net Neutrality

For the final exam in our Business, Government and Society class at IE Business School, we were required to write an "integrated strategy brief" for Netflix on the issue of net neutrality.

I share with you the paper I wrote. Please note that this paper was written under time pressure as we were given a fixed amount of time to read the case and complete our output.

What follows is the paper that I wrote. Happy reading!

Netflix Logo

Thesis Statement

There is a popular saying in my line of work that content is king but distribution is queen [i]. I believe that this, in a nutshell, helps to explain what lies at the heart of net neutrality issue. Content producers and distributors now lie on the same side of the fence pitted against ISP’s who are positioned to become the “gatekeepers” to consumers. ISP’s, who shoulder the majority of the infrastructure costs to bring the Internet into consumers homes, now want a piece of the pie and are threatening to disrupt distribution.

The objective of this strategy brief is to give an integrated view on the issue of net neutrality by examining the market and non-market factors at work that will help lead to a possible course of action or a roadmap to help Netflix survive and thrive in the years to come. I will begin with a simple analysis of market and non-market factors using two popular frameworks: Porter’s Five Forces and IA3 and wrap up with some concrete action steps to take in the short, medium and long-term including my best forecast of the desired outcomes and risks associated with each action.

Market Factors

The market for Internet content can be divided into content creators, content aggregators and content distributors. The threat of new entrants for content creators and aggregators is quite high but the threat of new entrants in content distribution (where Netflix mainly operates) is quite low, as it requires a lot of resources to build scale and a large consumer base.

The threat of substitute products is medium; such is the power of content. There is no easy substitute for an award-winning film but people can switch to doing another activity. This gives people who control content power. But at the same time, the very popularity of things can change over night depending on quickly changing consumer behavior.

Consumers are normally price takers when consuming content. However, the popularity of torrents is a big threat as piracy continues to be a major problem for content creators and content distributors. Why pay for something that is readily available for free?

Bargaining power of suppliers is high. Netflix is at the mercy of 3rd party content creators such as Disney as they need to allow distribution of their content on Netflix’s platform [ii]. This is why Netflix has now ventured into content creation also. At the same time, the growing strain on bandwidth has made ISP’s, such as Comcast, exert pressure on content distributors who they want to help shoulder part of the cost.

Competitive rivalry for Netflix is medium to low, as there appears to be little competition for the platform they provide. They control majority of TV streaming in the U.S. (63%) and are expanding to other parts of the world. Some direct competitors do exist, like Amazon and Apple, but they have not yet achieved the same level of popularity as Netflix.

The market that Netflix operates in is quite complex and the position they find themselves in now is tough. The obvious threats are that consumers shift to another form of entertainment (highly unlikely in the short-term) or that margins become so narrow (because of increasing costs to secure content and increasing costs to get the content through ISPs) that it becomes unprofitable to operate purely as a content distributor. Other competitors like Amazon and Apple have other businesses that can help subsidize any losses in content distribution.

There are some notable opportunities though. The market of Netflix is still very much U.S. centric. The potential to grow in other markets is very real. Another opportunity is the shift into content production. Although expensive, it looks quite promising given the success of House of Cards.

Non-Market Factors

The issue on net neutrality is a big concern for many parties. I have outlined a simple IA3 framework in Appendix 1 and will discuss the main points briefly below.

Content creators, distributors and everyday consumers are openly opposing regulations that threaten net neutrality while telecoms and ISP’s find themselves on the other side of the issue. The U.S. government is split.

From the point of view of content creators and distributors, they want to keep net neutrality, because they stand to benefit the most from equal internet speeds for all types of content without having to shoulder any of the burden. Looking at Figure 2 there are a few content distributors (Top 10 have 82.89%) that dominate majority of traffic.

From the point of view of ISP’s, they are burdened with having to provide greater bandwidth to consumers at faster speeds (to cope with greater consumer appetite for streaming) but are unable to capture any of the additional value they are providing. Some ISP’s, such as Comcast, have ventured into content (through the acquisition of NBC Universal) as a means to capture some of this value.

For consumers, mergers have left them with little choice and the likely scenario of having to pay more for a service than is likely to deteriorate with time.

The issue is currently being played out in the US court system, Congress, and in the media. Many of those threatened are large media companies that have gone on the offensive to try and swing public sentiment to their side. The courts, however, have already awarded the first major win to the ISP’s.

Both parties have provided information and assets that look to swing the decision to their side.

Road Map

Given the above, below are a few recommendations that I think may work to help ensure that Netflix survives and thrives in the marketplace.

In the U.S., I propose the following action plan:

In the short-term, I would lock into place pricing schemes with ISP’s that would ensure that Netflix subscribers continue to receive the same level of service as they have in the past. In reality, Netflix should have anticipated this and done this a long time ago. Had it locked preferential pricing early on when its traffic was not yet substantial, it could have enjoyed much lower rates. Shortsightedness has cost Netflix an opportunity to act before the situation became dire.

Admittedly, by doing this, Netflix concedes that net neutrality in its current form is dead. This is a short-term loss on the part of Netflix. However, it ensures that the service is not disrupted which is needed to safeguard the core business.  On the upside, it hands the burden of providing fast Internet speeds back to ISP’s and can put the blame (and any negative consumer backlash) on them for any future disruption in the service.

In the medium-term, I will continue to align with fellow Internet giants and small startups and form a coalition that will look to alter the way ISP’s are regulated and push to open competition. An organized and homogenous coalition can paint the picture of ISP’s being greedy while playing gatekeeper to consumers. The coalition would look to push for Internet to become a utility to bring it under the regulations of the FCC. The European (and possibly even Asian) case study should be used as a benchmark for what can be accomplished with ISP’s opened to competition. The risk to this is that it will cost a lot of time, money effort to push for this type of regulation. And in the end, it may not even work as it is highly dependent on who controls Congress.

In the long-term, I will look to work with ISP’s to improve infrastructure. This can be done through a partnership or quite possibly even via acquisition. If ISP’s are successfully opened to competition, the ability to start our own ISP is very real and with it the ability to improve infrastructure. An alternative to this is to partner with Google and become an active stakeholder in their push to increase coverage of Google Fiber. The risk to this is that both options will require massive investments in CAPEX. However, it will give Netflix more control of the value chain, a logical step to take after already venturing into content creation.

In Europe, where net neutrality looks like it will be kept, I will fast track the expansion plan for Netflix. There is a need to diversify outside of the U.S. and the environment in Europe looks like it is suitable. Penetrating Europe will not be as easy though, given that consumer tastes are quite different. As such, there is going to be a need to form strong partnerships with local content creators and quite possibly even a push towards content created by Netflix specific for European markets.

By diversifying further into content creation, Netflix moves into a part of the value chain where it can capture more value as opposed to the low margins that exist simply as a distributor. Main risk to this is that Netflix may not have the necessary expertise in European tastes and securing this expertise is bound to cost a lot of money.

Appendix 1: IA3 Framework

[i] http://www.forbes.com/sites/peterhimler/2013/07/09/content-is-king-distribution-is-queen/
[ii] http://money.cnn.com/2012/12/04/technology/netflix-disney/