The Brilliance of Netflix’s Business Model
An Introduction Into Scalability & Horizontal Supply Curves
2018 was a very good year for Netflix.
- They increased their total number of paying subscribers to nearly 140 million worldwide, up from 110 million in 2017.
- These new subscribers allowed them to increase their revenues by 35% to $16 billion.
- Their operating profits doubled to $1.6 billion.
- They are forecasting an additional 8.9 million new subscribers in the first quarter of 2019, bringing their total to nearly 150 million paying subscribers worldwide.
Streaming has Incredible Scalability
The amount of a product a company is willing to produce is based on their cost of production and the price they can sell their product for in the market place.
A company will continue selling its product until the marginal cost of producing one additional unit of that product is equal to the marginal revenue, they will receive from selling that additional unit of its product.
If you had a company selling t-shirts, and you could make the shirts for $9 and sell them for $10 it would sense for you to keep making shirts. If, however, it costs you $11 to make a shirt and you could only sell it for $10, you would stop making shirts.
In economic terms, a firm is maximizing its profits when marginal revenue = marginal cost.
For industrial products made in a factory, there are additional costs that are incurred for producing more of your product. If you were to double production, you would need to hire more labor, invest in more machinery, buy a bigger warehouse etc… If the price of the product you sell is not increasing, it won’t be long before the marginal cost catches up to the marginal revenue.
For a digital company like Netflix, the cost of selling one additional membership is close to $0. Don’t get me wrong, Netflix has huge costs and has taken on massive amounts of debt in order to produce the volume of content it has over the past few years.
However, their costs hardly change from having 140 million subscribers and 140 million and one subscribers. They don't need a bigger factory or hire additional labor to “produce” one additional membership.
Netflix has a constant marginal cost which means it would be willing to sell as many memberships as they possibly can. They would sell a membership to every person on planet earth if they could.
This is represented by a horizontal supply curve.
Put simply, Netflix has a product that is completely scalable.
Scalability allows a company to meet the demand of consumers in almost every situation.
Going back to our t-shirt business example. If you had a factory that could produce 10,000 t-shirts per month, you have limited scalability. If the demand for your t-shirts doubled to 20,000 per month you would not be able to increase your production and meet demand without upgrading to a larger factory (which you may not have enough money to do).
With a digital product like the one Netflix sells, they do not need to worry about such limitations. They have scalability.
Investors love a business that has scalability because they believe that as a company grows its revenues over time it will also increase its profits. As a result, Netflix stock price has increased by more than 37,000% since the company went public in 2002.
Success is not Guaranteed
Netflix has a completely scalable product that millions of people love. Their subscription base, revenue, and stock price have been soaring for years and they have virtually no barriers to meet consumer demand.
That does not mean however that their profits will continue to grow.
As mentioned previously, even though their marginal costs are low their fixed costs are very large. They have taken on more than $10 billion in debt to produce and market their library of content.
With Amazon, Disney, Hulu, and Apple all set to enter the streaming market, Netflix will soon face greater competition than ever before.
The key question for Netflix will be if it can continue to grow its paid subscriber base in the face of such stiff competition from companies that can outspend them?
Having low marginal costs only helps if people continue buying more of your product.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.