Is Netflix Spending Too Much to Acquire New Subscribers?

Netflix Tax

Netflix has more than tripled their subscriber volume since 2011. The way they did it wasn’t as organic as you might expect. They effectively purchased new viewers through their trial month program and other novel marketing tactics, and their strategy worked to perfection. Netflix’s calculated gambled has paid off to the tune of tens of millions of new subscribers. Here’s the math of a strange but lucrative business gamble.

Around the time of their Qwikster announcement and the ensuing PR debacle Mashable described as the worst launch since New Coke, Netflix owned less than 23 million users. Their second quarter of 2016 earnings report revealed just how far the company has come in less than five years. Netflix’s American service includes 47 million active subscribers, while they’ve simultaneously expanded their international appeal. Netflix is effectively the world’s most popular television channel thanks to its 83 million users.

How did their business earn such a loyal following?

Destroying Conventional Television: The Rise of Netflix

Part of their triumphant story is undeniably the business model itself. Netflix almost single-handedly introduced the world to the concept of streaming media consumption, thereby accidentally destroying conventional television. Research suggests that only 75 percent of viewers aged 18 to 34 watch any kind of traditional television, the lowest percentage on record. The 18-24 demographic consumes less than 15 hours of television per week, a fraction of the 50+ hours that people over 50 watch. Both of these 34-and-under numbers are historically unprecedented. Netflix fundamentally altered a basic viewer behavior that had remained unchanged since the 1950s.

In order to achieve such a stunning feat, they had to pay to play, so to speak. In the months leading up their pivot from their original business model as a DVD-by-mail delivery service, Netflix added two wrinkles to their playbook.

Gifted a Netflix Subscription…from Netflix

The first was that they started providing a free month of service for their fledgling streaming division. They hoped that they could entice fence-sitters to sample the new merchandising, hooking up with one of the oldest marketing strategies in the world. The first taste was free, but the ones after that cost $7.95 per month.

The math checked out on this business strategy during its smaller scale testing phase. During the first quarter of 2010, 226,000 users tried the service, with the majority of them maintaining their subscription after the free trial ended. By the third quarter of 2010, Netflix had complete confidence in the practice. They started that quarter with 424,000 free trials. Only three months later, more than a million people were willing to give Netflix’s new streaming service a shot. They more than doubled their base of non-paying customers, gambling that they’d stay long enough to recoup the operational costs involved.

The second financial change was their new focus on marketing. They understood that they’d have to buy new customers in order to offset the hefty costs of running an online digital service. Even today, companies suffer dramatic losses when incorrectly anticipating demand for their streaming services. Hosting thousands of servers comes with a level of sticker shock that’s only tolerable when the monetization process is just around the corner. In 2011, the cost of what Netflix was attempting stood apart as a truly stratospheric financial outlay. It was a move that took guts.

Netflix’s decision makers, led by company founder Reed Hastings, all believed that their core concept was sound. Consumers would quickly turn to streaming video once they understood its benefits. The trick was how to seduce them away from 60 years of established behavior with regards to media consumption.

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The way that they accomplished this tactic was through ad buys. Netflix eschewed conventional advertising strategies, instead gambling that their customers would respond to original tactics. After all, the service itself was an emerging technology attempting to entice early adopters. Why would conventional advertising work? Instead, they marketed their product via cutting edge internet marketing. The Netflix banners were ubiquitous throughout 2011 and 2012. Each click meant a potential long-term customer for the company, but they had to kill off the dying part of their company first.

During the first quarter of 2011, Netflix prepped their exit strategy for the DVD by mail program. They laid the groundwork with the loss leader of free subscriptions. Estimates placed this option at 1.7 million during that first quarter, with shockingly few people quitting after the first month. That effectively halved the cost of the “free month” into a “buy one, get one free” service, a much more palatable ledger sheet proposition. Many of those early adopters became long-term streamers. Best of all, they weren’t just Netflix loyalists; they were also Netflix evangelists.

The $12 Billion Cost of Qwikster

Still, the Qwikster speed bump and its lingering fallout set back the company a great deal. Their initial plan for hooking people through free subscriptions and raised awareness via internet advertising should have excelled beyond their wildest dreams, something it eventually did. Alas, the “raised awareness” they received in the wake of Qwikster wasn’t the kind that increases subscriptions. To wit, Netflix lost 800,000 users in a single quarter.

As the company entered 2012, they recognized that they’d have to buy their way out of trouble, a dangerous tactic that fails much more often than it succeeds. Fortunately for Netflix, they had the type of product that fosters forgiveness. During the calendar year of 2012, Netflix bought back trust at a cost of hundreds of millions of dollars. Their marketing outlay for 2012 was $218 million, an expense that seemed almost incomprehensible at the time for a company that had lost $12 billion (!) in market cap.

You Personally Cost Netflix $22.25!

From a subscriber perspective, Netflix expanded to 33.3 million during the same year, an increase of almost 10 million from their starting point of 23.5 million. In other words, they spent $218 million in advertising to gain 9.8 million new subscribers, a cost of roughly $22.25 per person. That’s a bit of an exaggeration since companies also use their marketing budget to reinforce the loyalty of existing customers as well as subliminally appealing to potential subscribers down the line. Still, they paid a dramatic amount relative to the customer inroads they made.

Fine, You Only Cost Netflix $8! Wait, When Did You Sign Up?

In 2013 and 2014, the company advertised less while gaining more traction as the worldwide leader in media streaming. They purchased $143 million in ad buys in 2013 followed by $121 million in 2014. That’s right. They spent almost $100 million less in 2014 than 2012, although this figure is a bit misleading for reasons discussed below.

During that same timeframe, their subscription base increased from 33.3 million to 57.4 million. Effectively, they purchased 24.1 million viewers for an aggregate cost of $264 million. That’s an expense of less than $8 per new customer, barely a third of the $22.25 the Qwikster disaster forced them to spend.

First World Business Problems: Ubiquity Division

The concern for Netflix moving forward is that they’ve reached a point of diminishing returns. Now that they’re ubiquitous in American culture straight down to the Netflix and Chill meme, the business cannot do much else to boost their awareness. That’s why they’ve ramped up their international expansion in recent years.

Still, Netflix strategists recognize an important detail about their business. Yes, they claim 47 million American subscribers, but the country’s population is roughly 323 million. America possesses an estimated 124.6 million households. From Netflix’s perspective, less than 38 percent of American households subscribe to their service. The business wants to keep boosting that number to enhance their position of dominance within their industry.

In order to accomplish this goal, Netflix has to keep spending a great deal of money. How much are we talking? During the fourth quarter of 2014 alone, Netflix paid for $203.7 million in advertising, which was up a whopping 59 percent from the same quarter in 2013. What did they get for their money? During that period, subscriptions increased from 69.2 million to 74.8 million. Those new 5.6 million customers cost Netflix $36.38 each. Before your jaw hits the floor, you should understand that there are some caveats.

International expansion is always costly for a global corporation. One-time charges exist in building infrastructure, and ongoing expenses such as local translations of television shows and movies are also a factor. In the United States alone, Netflix’s spend was a much more tolerable $87.4 million, a much less substantial year-over-year increase of 24 percent. For that money, their paying customers increased 19 percent, a perfectly reasonable ratio. Still, that’s not a sustainable business practice over the long term.

Marco Polo Cost Netflix a Lot more than $22.25

You’ll note that the $203.7 million figure on its own is more than they allegedly spent for the entirety of 2014 according to Statista. The explanation for this odd incongruity is that Netflix oftentimes includes their entertainment purchases in this category. What does that mean on a basic level? When you watch a new series like Jessica Jones or Stranger Things on Netflix, they’re writing that off as an advertising expense even though it’s not. And the way they handle these transactions is quite unorthodox.

Here’s the most extreme example. Netflix licensed 10 episodes of Marco Polo, which debuted in late 2014. Marco Polo came with a financial outlay of $90 million, which is mind-boggling in and of itself. Inscrutably, Netflix doesn’t list this cost until the show premieres and only then as an ad cost, meaning that they call Marco Polo a marketing expense in their budget reports. They don’t charge it against the books until it airs, though. This leads to reporting irregularities such as a company somehow spending $121 million in advertising for an entire year while they claim that they spent $90 million on a single show. Whenever you read financial data about Netflix, pay attention to the finer points since they’re redefining many areas of entertainment finance.

What’s important is the pink elephant dancing in the living room. Netflix has to buy new consumers, and the best way they’ve unearthed to accomplish this goal is through exclusive content. They can afford this tactic as long as the financials make sense. They have more than 75 million paying customers, and their second quarter earnings were $2.11 billion.

The potential early warning signal that’s spooking business analysts and stock investors is that its growth is stagnating. During the period from May to July, only 160,000 new American subscribers joined the service. Its overseas growth of 1.52 million was exponentially better, but it’s fair to say that Netflix is currently maxed out with in the United States. They must deduce a new tactic to get the 60+ percent of the population that doesn’t currently subscribe to change their collective minds. They can’t keep paying a larger portion in marketing to entice new viewers indefinitely. Netflix is wonderful, but competitors will eventually eat into its market share if it doesn’t find new ways to entice fence-sitters to convert. What worked in 2011 doesn’t have the same success rate today.