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Netflix has long been the poster child of the online video-streaming subscription business. In a surprising change of direction, last month it tied up with Microsoft to offer cheaper, ad-supported streaming plans to consumers. The move kickstarted debates on whether this would dent its core proposition. Will subscribers, who have been paying a premium already, feel they are now paying merely to avoid advertisements?

Recent numbers from Netflix, which has about 221 million subscribers, show this is a risk it had to take. After a decade of consistently gaining subscribers, including through the pandemic, it lost 1.2 million in the first half of 2022. This showed that the pandemic did not fundamentally alter consumer behaviour, and some of Netflix’s gains were just a temporary bump.

This is reflected in financials. Netflix’s revenues were growing at 15-25% through the pandemic, but the rate dropped to 9.8% and 8.6% in the last two quarters. While a drop in topline growth is normal for a business that posted revenues of $30 billion in 2021, operating margins have also been dropping: from 22.8% in Q3 of 2021 to 19.3% in Q2 of 2022.

Adding advertising to its business model is intended to help on both counts. Ad-enabled, cheaper subscriptions are intended to expand the pool of potential subscribers. Further, Netflix can then also earn from ads. Digital ad spending in the US alone was nearly $240 billion in 2022 and is expected to cross $315 billion by 2025, according to eMarketer. Netflix is currently not tapping any of this.

International expansion

In the past few years, international markets drove growth for Netflix. While its US and Canada subscriber base grew just 18% between Q2 of 2018 and Q2 of 2022, its subscribers from Europe, Middle East and Africa grew 133% and Asia-Pacific 316%. With about 73 million Netflix subscribers in the US and Canada, the headroom for growth there is limited. International markets, especially Africa and Asia, are likely to be growth drivers in the coming years too.

Netflix has laid considerable groundwork on this front, expanding in phases and catering to specific local needs. “Recognizing that in some parts of the world, particularly emerging and developing economies, mobile is the primary way most people access the internet, Netflix also began placing a greater emphasis on improving its mobile experience," Louis Brennan, a professor at the Trinity Business School Dublin, wrote in Harvard Business Review. To leverage these, Netflix has to offer more tiers to reach out to a larger audience.

Lower realizations

Netflix grew in international markets by lowering subscription rates. Its average revenue per user (ARPU) in the US and Canada is almost double of that in Asia-Pacific and Latin America. Even within these markets, there is room for pricing options. According to an analysis by Comparitech, its ARPU in India ($9.70) in Q1 of 2021 was the same as the ARPU in richer countries such as Australia, New Zealand, Singapore and South Korea. Argentina and Brazil have a lower ARPU at $7.40.

Additional pricing tiers can also check the practice of password sharing. Netflix says 100 million households use shared passwords. It has recently started asking customers in Argentina, El Salvador, Guatemala, Honduras and the Dominican Republic to pay an extra fee if the account is used in more than one home. It will eventually roll it out to its other markets. Cheaper tiers could convert some of those users into paying customers.

Content is king

The fundamental challenge for Netflix is to retain existing subscribers even as it expands its customer base. To retain customers, it has to constantly provide high-quality original content. It spent about $17 billion on content in 2021, a year-on-growth of 44%. It has helped. Netflix CEO Reed Hastings recently acknowledged that the firm might have lost even more subscribers if it had not been for its popular series 'Stranger Things'. As it expanded internationally, it has also been spending on domestic content, which has helped to bring in more audiences.

To expand its customer base, especially in international markets, it has to bring its price down, without denting its operating margins. While the higher number of customers would offset some of the costs, it might not be enough given the appetite for domestic content. An ad-supported tier will help the company achieve that.

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