China Makes Sense For Netflix, But It Won’t Be Easy

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Streaming giant Netflix (NASDAQ:NFLX) is reportedly in talks with Chinese online broadcasting companies about bringing its content to China. [1] The company has reportedly spoken with Shanghai-based BesTV New Media Co. and Wasu Media Holding Co., a Chinese media company backed by Alibaba Group Holding Ltd. Executive Chairman Jack Ma. No deal has been made public yet but this development could pave the way for Netflix to enter China’s booming online video industry. Netflix had earlier stated that they were interested in entering the country and were exploring “modest” options for doing so. [2] Expanding into China will be a good move for Netflix but it will not be easy sailing for the company.

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Why China Makes Sense

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Netflix has stated earlier that the company intends to continue expanding internationally and China seems a logical choice. China’s online video market grew 77% in 2014 and generated 23.97 billion Yuan ($3.88 billion) in revenues. [3] The online market is expected to triple and touch 90 billion Yuan ($14.5 billion) by 2018. China had 649 million internet users by the end of 2014, most for any country in the world. [4] According to the 2010 consensus conducted by the National Bureau of Statistics, China had an average figure of 3.1 persons per household. [5] Using this figure, and assuming one connection per household, we estimate that China has close to 209 million internet households. Around 27% of China’s internet connections have connection speeds of 4 Mbps or above, the minimum speed recommended for streaming high definition content. This essentially means that entering the Chinese online video market will give Netflix access to a potential market of about 56.5 million broadband households. In comparison, the company’s launch in France, Germany, Austria, Switzerland, Belgium and Luxembourg last year gave it access to about 66 million broadband households. [6]

China has a population of about 1.369 billion [7] and has approximately 442 million households. (Total households=Total Population/Average persons per household.)  According to PWC Hong Kong, 237.6 million Chinese households subscribed to a pay-TV service in 2013. [8] Assuming that these subscriber households grew by 10% last year, China would have had around 261 million pay-TV subscriber households by the end of 2014. This pegs China’s pay-TV penetration at under 60% in 2014. In comparison, the pay-TV penetration in the U.S. is around 84%. [9]  This is an indication that pay-TV penetration is relatively low and this scenario will benefit Netflix.

It Will Not Be Easy Sailing

Online streaming is a very restricted domain in China. China’s State Administration of Press, Publication, Radio, Film and Television has given Internet TV licenses to only seven companies, with Wasu being one of them. Netflix would most certainly need to partner up with a company that has licenses to distribute content on all platforms, including computers, mobile phones and set-top boxes. China also has a very strict censorship policy and the concerned authorities could object to some of the potentially objectionable content in Netflix’s programming.

Another major obstacle in Netflix’s path to a successful foray into China is piracy. Piracy-tracking firm Excipio reported that the show’s season three was downloaded illegally around 682,000 times within the first 24 hours of being available on torrent services. [10] The show was pirated the most in China with more than 60,000 downloads. Downloading from torrents is not the only method to illegally view Netflix shows. GlobalWebIndex estimates that 20 million viewers watch Netflix through virtual private network (VPN) services in China. Piracy has a direct effect on the attractiveness of Netflix’s exclusive programming. Subscribers may not be interested in viewing these shows at Netflix’s paid platform when they can get the same shows for free.

Impact Of Netflix’s Expansion Policy On Its Subscriber Base And Margins

Going forward, Netflix’s international expansion could have a significant impact on both its subscriber additions as well as its contribution margins. The company launched operations in France, Germany, Austria, Switzerland, Belgium and Luxembourg in September 2014, which gave it access to a potential market of about 66 million broadband households. [6] In March 2015, Netflix launched its services in Australia and New Zealand and met with a positive initial response. The company is also poised to launch into Japan later this fall. (Related – A Closer Look At Netflix’s Foray Into Japan) Other than China, there are some other Asian countries with fast Internet service that Netflix could venture into later, including Hong Kong, Singapore and South Korea. The subscriber growth in the International segment has been very robust so far, with the subscriber base increasing from 1.9 million customers in 2011 to almost 21 million as of March 31, 2015. We believe that Netflix can cross 60 million international subscribers by the end of our forecast period if it continues on its current expansion plans.

Netflix’s international operations are still unprofitable as the company continues to invest heavily in its expansion. However, the markets that Netflix launched into prior to 2014 (Canada, Latin America, the UK, Ireland, the Nordic countries and the Netherlands) became profitable on a contribution basis in Q3 2014 and continue to grow. [2] The company acknowledges that progress has been so strong that it now believes it can complete its global expansion over the next two years while managing to still be profitable. This is possible as Netflix will start experiencing operational efficiencies as it grows operations in the target countries. The marketing expenses will also come down as a percent of sales once the company establishes itself in these countries. We believe that Netflix’s international segment will start to break even by 2017 and will start having meaningful positive contribution margin from 2018 onward.

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Notes:
  1. Netflix in Talks to Take Content to China, May 15, 2015, Wall Street Journal []
  2. Q4 14 Letter to shareholders, Netflix Investor Relations [] []
  3. 2014 Sees Huge Rise in China Online Video Revenues, February 28, 2015, iResearch Consulting Group []
  4. China’s internet population hits 649 million, 86 percent on phones, February 3, 2015, Reuters []
  5. Sixth National Population Census of the People’s Republic of China, Wikipedia.org []
  6. Q3 14 Letter to shareholders, Netflix Investor Relations [] []
  7. China Population Clock, National Bureau of Statistics of China []
  8. Key insights at a glance, PWC Hong Kong []
  9. U.S. pay-TV penetration flat at 84% of homes … and Netflix has little to do with it, study says, FierceCable []
  10. ‘House of Cards’ Season 3 Pirated, With China Top Country for Downloaders, March 1, 2015, Variety []