Will Netflix get boxed out overseas?

In its second quarter earnings report Tuesday, Netflix announced it will expand into a new, European market in the fourth quarter, adding to its current presence in the U.K. and Ireland, which will push the company’s earnings temporarily back into the red. For several quarters after that, in fact, the company said it plans to plow profits from its domestic business, including the $6 million it earned in the second quarter, into its international expansion drive, adding one new market each time it returns to global profitability after the previous expansion. That will keep consolidated earnings more-or-less on a break-even pace for the foreseeable future.
Investors hated the idea, sending shares of Netflix down more than 25 percent to a new 52-week low.
If you’re not a Netflix investor, however (or if you’re a very patient one), it’s not an unreasonable long-term plan. Domestic growth is clearly slowing, as shown in the second quarter net subscriber adds, which came in at 50 percent of the net adds in the second quarter of 2010 (Netflix does not use 2011 as a basis for year-on-year comparisons because the catastrophic price hike and attempted DVD spin-off he went through make last year’s numbers anomalous). Netflix has no choice but to look overseas if it is to rekindle growth, and its measured, market-by-market approach spares the long-term balance sheet even if it’s hard on the income statement in the near-term.
The obvious strategy doesn’t necessarily mean an easy one, however. Unlike its previous expansions into Canada and Latin America, where competing subscription streaming services were scarce, Netflix will face a stiffer fight in Europe, where well-heeled operators like Amazon-subsidiary LoveFilm and BSkyB’s recently launched Now TV service are going after the same viewers.
While Netflix talked confidently in its second quarter letter to shareholders of its ability to compete with those services, the same earnings report was bracketed by a pair of announcements that could raise that bar higher than Netflix is anticipating.
On Monday, Amazon announced the opening of a new global digital media hub smack in the middle of London. According to the announcement, the new hub will pool LoveFilm’s existing development staff, along with those from TV app developer Pushbutton, which Amazon acquired last year. The combined staff will focus on “the creation of interactive digital services for TVs, game consoles, smartphones and PCs…and the building of services and APIs that power that digital media experiences,” Amazon said. The moves sends a clear signal that Amazon intends to incorporate LoveFilm into a broader, more ambitious and device-focused strategy.
The announcement also comes as Amazon is preparing to roll out a pair of new Kindle Fire tablets with revamped software more suitable for video and other graphic-intensive apps, which will give LoveFilm a further hardware boost in the U.K.
Newly launched Now TV could also benefit from a recent hardware development. On Wednesday, News Corp. and U.K. satellite service BSkyB (40 percent owned by News Corp.) led a $45 million funding round into streaming set-top box maker Roku, which the companies described as a “strategic investment.”
As Netflix noted in its shareholder letter, at £15 a month, a subscription to Now TV is more than twice that of a Netflix subscription in the U.K., the service will now likely come embedded in Roku boxes and can be bundled with a BSkyB subscription, making the cost transparent to the consumer.
Roku boxes, of course, also come bundled with Netflix and Netflix was a founding investor in the company. But Netflix could now find itself competing on those boxes with a bundled service that also includes linear TV content. Roku has also not been shy about dropping content providers from its platform that compete with its strategic partners. In the wake of an earlier strategic investment by Dish Network (rumored to a silent participant in the latest round as well) Roku removed more than 25 channels with foreign-language content and made Dish’s DishWorld service the exclusive provider of foreign programming on the platform in the U.S.
There’s no certainty that Roku would do the same to Netflix in the U.K., but the precedent is there.
Netflix’s app is already embedded a wide range of connected devices, of course. But in international markets it lacks the leverage it enjoyed in the U.S. from its existing base of DVD subscribers to easily convert those embedded apps into streaming subscriptions. Instead, it finds itself facing off against indigenous players whose services are part of integrated device-plus-services strategies at a time when consumers increasingly are looking for integrated solutions, especially as they do more of their video viewing on mobile devices rather than fixed ones.
This time, it could be Netflix that lacks leverage.

Question of the week

Does Netflix need a strategic hardware partner?