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Amazon  takes  on  Netflix  with  on-‐line  video  streaming  

MBA    211.1  

Mrs.  Bento’s  Box  

Game  Theory  –  Prof.  J.  Morgan  

MBA    211.1  

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“While   the   latest   to   join   the   bandwagon   is   Facebook,   other   competitors   that   are   looking   to  

expand   include  Amazon.   This   could   potentially   disrupt  Netflix's   accelerated   user   base   growth,  

which   is   the   key  metric   for   sustaining  Netflix's   growth  and   frothy   valuation   […]  Netflix's   stock  

price  fell  about  20%  from  its  peak  of  about  $247  before  recovering  to  around  $215.  It  seems  that  

investors  are  now  getting  more  cautious  regarding  competition  and  Netflix's  outlook.  [...].  Could  

this  be  a  sign  that  Netflix's  stock  is  topping  out  in  the  near  term?”1  

   

                                                                                                                         1  http://community.nasdaq.com/News/2011-‐03/facebook-‐stepping-‐on-‐netflixs-‐toes-‐with-‐streaming-‐movies.aspx?storyid=62782  

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1. The  online  streaming  video  market  

On-‐line   streaming   is   fueling   growth   in   the   movie   rental   market,   and   is   becoming   an  

increasingly   attractive  market.    While   the   off-‐line  movie   rental  market   in   the  U.S.   has  

been  stable  at  about  $8  billion  over   the   last  4  years,   the  on-‐line  market  has  spurred  a  

growth   of   70%   annually   reaching   $2   billion   in   2010.     The   main   reasons   behind   this  

growth:    

a. The   technology   needed   is   ready   and   barriers   to   entry   are   low,   thanks   to   the  

explosion  of  available  bandwidth  and  broadband  penetration,  the  proliferation  of  

media-‐enabled  connected  devices,   the  availability  of  online/connected  TVs,  and  

the  commoditization  of  delivery  technologies  

b. Consumers   are   welcoming   the   new   medium,   as   the   %   of   total   video   usage   is  

shifting   favorably   towards   Over-‐the-‐Top   video   (“OTT”)   (although   the  

predominant  platform  is  still  traditional  linear  TV)2  

                                                                                                                         2  Source:  iConsumer,  2008-‐10;  U.S.  13-‐64  year-‐old  Internet  users;  DC1,  DO6,  and  V19    

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Figure  1:  In  the  US,  OTT  penetration  of  internet  users  has  tripled,  driven  by  proliferation  of  access  options  

c. Many  players  in  the  value  chain  are  eager  to  enter  the  market:  content  creators  

(e.g.,   Disney   and   HBO),   on-‐line   distributors   (e.g.,   Netflix,   Hulu,   Google   and  

Amazon),   and   cable   access   providers   (e.g.,   Comcast   and   DIRECTV),   are   all  

trying/have  entered  the  market  in  a  very  short  time  span  

 

2. Netflix  has  been  the  most  successful  player  so  far  in  the  OTT  business  

Netflix  was   founded   in  1999  offering  a  DVD  rental  mail-‐order  service.    This  successful  business  

model,   which   allowed   Netflix   to   outperform   classic   brick-‐and-‐mortar   competitors   such   as  

Blockbuster,  started  shifting  in  20073,  when  the  company  added  on-‐line  streaming  to  its  offering.    

So   far,   this   business   model   shift   has   proven   to   be   highly   successful   to   the   California-‐based  

company,  as  the  share  of  subscribers  who  are  using  the  online  service  has  tripled  over  the  last  3  

years  (from  22%  in  2008  to  68%  in  2010).    

                                                                                                                         3  Source:  Netflix  annual  and  quarterly  reports;  Netflix  website;  Yahoo  Finance  

... gaming consoles have gone mainstream, and are the preferred device for watching OTT content on TV

Other18

PC connect-ed to TV 13

Gaming console37

DVD/DVRwith internet capability20

Internet-enabled TV

11

TV-based OTT users havealmost tripled ...

4

6

7

83

~3x

2010

24

17

09

15

9

2008

5

OTT users1% of respondents

Preferred device to watch OTT content on TV% of OTT users

Habitual OTT users2

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Analysts4,   however,   disagree   on   whether   Netflix   will   be   able   to   strive   in   the   new   market   as  

successfully  as  it  has  done  so  far.    On  one  hand,  the  decrease  in  DVD  mailings  will  reduce  tied-‐up  

capital  and  thereby  allow  Netflix  to  invest  in  additional  content  for  its  streaming  offering,  which  

so  far  only  lists  20  thousand  titles,  containing  mostly  outdated  content  (T2  analyzed  how  many  

out   of   the  most   popular   120  movies  were   on  Netflix’s   and  Amazon’s   catalog   in   a   given  week,  

resulting   in  17   for  Netflix   and  62   for  Amazon’s  pay-‐per-‐view   service).    On   the  other  hand,   the  

rapid  growth  of  the  market  is  attracting  many  strong  and  resourceful  players,  forcing  Netflix  to  

quickly   ramp-‐up   its   investment   in   on-‐line   content   under   the   threat   that   newcomers  will   offer  

wider  catalogs  and/or  more  competitive  prices,  thereby  attracting  more  customers.  

 

3. Amazon  has  recently  started  offering  online  streaming  for  free  to  its  Prime  customers  

Amazon,  the  largest  multinational  e-‐commerce  company,  was  founded  in  1994  and  has  been  one  

of   the   strongest   growing   retail   companies   of   the   last   20   years.   In   the   past   few   years,   it   has  

started   expanding   its   business,   first   by   expanding   the   breadth   of   products   sold   (from   books,  

media  and  electronics,  to  auto  parts  and  home  hardware),  then  by  moving  to  virtual  goods  (e.g.  

mp3  music   and   e-‐books,   also   with   the   launch   of   its   e-‐book   reader,   the   Kindle)   and   finally   by  

capitalizing   on   its   synergies   to   offer   non-‐retail   services   (e.g.,   Amazon   Web   Services,   on-‐line  

                                                                                                                         4  Source:  Morgan  Keegan,  “Thoughts  on  Amazon  Prime  instant  videos”,  T2  partners  LLC  “Why  we’re  short  Netflix”  

The  success

Net  income,  USD  million

7 2247 49

67 83116

161

0

60

120

180

2003 04 05 06 07 08 09 2010

Subscribers,  million

1 34

6 79

12

20

0510152025

• Consumer  base  CAGR  of  45%

• Revenue  CAGR  of  57%

• Stock  traded  at  $175.70  on  December   2010,  >25x  more  than  2002  issue  price  (45%  CAGR)

Figure  2:  Development  of  Netflix  net  income  and  subscribers’  base  

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payments,  credit  cards).  At  the  end  of  February  2011,  Amazon  announced  the  introduction  of  an  

unlimited,  commercial-‐free,  instant  streaming  service  for  its  Prime  members5.    Analysts  interpret  

this  move  as  both  an  offensive  and  a  defensive  strategy6  for  the  following  reasons:  

• Amazon  might  be  entering  the  movie  streaming  business  with  a  value-‐priced  and  more  

compelling  offering  to  diversify  and  monetize  the  increasingly  attractive  market  

• Amazon   is   strengthening   the  value  proposition  of  Prime   to   increase   its   customer  base.    

Prime  members  spend  on  average  3  times  more  than  the  average  customer,  offsetting  

shipping  costs  and  yielding  profits  for  Amazon.   Increasing  the  growth  rate  of  the  Prime  

customer  base,  currently  at  25%,  as  well  as  holding  current  Prime  customers,  seems  to  

have  a  strong  positive  impact  on  Amazon’s  bottom  line.  Therefore,  enhancing  the  Prime  

value  proposition  can  be  a  sound  strategic  move  

• Amazon  recently  acquired  Lovefilm  (Netflix’s  counterpart   in  Europe,  still  using  the  DVD  

mail-‐order  model),  and  may  want  to  hedge  against  a  future  declining  DVD-‐mailing  rental  

market  

• By  bundling  movie  streaming  for  free  with  its  Prime  offering,  rather  than  offering  it  at  a  

cut-‐rate   price,   Amazon   is   following   the  moves  Microsoft  made  with   Internet   Explorer.    

Many  customers  will  become  accustomed  to  having  streaming  for  “free”,  and  thus  will  

not   subscribe   to   Netflix,   depriving   the   firm   of   the   revenues   it   needs   to   improve   its  

product  via  content  acquisition.  

Nevertheless,   the   streaming   offer   from   Amazon   is   quite   slim   compared   to   Netflix’s,   as   only   5  

thousand   titles   are   listed   so   far   in   their   catalog   and   the   Amazon,   most   of   which   are  

documentaries   and   independent  movies.  Moreover,   Amazon’s   offer   is   only   compatible  with   6  

                                                                                                                         5  $79/year  for  free,  unlimited  2-‐day  shipping,  source:  Amazon.com  6  Source:  Caris  and  Company  

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different   platforms   (e.g.   PCs   and   Apple,   but   not   Wii   or   Xbox)   compared   to   13   for   Netflix.    

However,  analysts  are  placing  strong  bets  on  Amazon,  if  it  is  willing  to  improve  its  content.  

 

4. Game   theory   shows   that   in   the   short   term  both  players  will   probably   accommodate,   but   as  

competition   becomes   stiffer   in   the   future,   both   players  might   decide   to   fight   to   increase   or  

keep  their  customer  base  

It   is   possible   to   estimate   the   current   impact   on   Amazon’s   EBIT   as   a   function   of   spending   for  

content   licensing  and  growth  of   the  customer  base  driven  directly  by  on-‐line  streaming.     If  we  

assume   that   the  Prime  annual   fee  of  $79  goes  directly   to  offset   content   costs,  not   taking   into  

account  the  additional  shopping  volumes  of  Prime  vs.  average  users,  and  that  current  spending  

on  content  is  $100  million  a  year,  then  Amazon  needs  circa  1.3  million  customers  to  join  Prime,  

who  wouldn’t  join  without  the  streaming  offer,  to  break  even.  

   Content  spend  in  USD  millions      

Growth  rate  per  year  

Customer  net  adds  to  Prime  due  to  streaming  (millions)   100     300     400     900     1,200    

0%   0.0     (100)   (300)   (400)   (900)   (1,200)  25%   1.3     (1)   (201)   (301)   (801)   (1,101)  50%   2.5     98     (103)   (203)   (703)   (1,003)  

100%   5.0     295     95     (5)   (505)   (805)  125%   6.3     394     194     94     (406)   (706)  150%   7.5     493     293     193     (308)   (608)  200%   10.0     690     490     390     (110)   (410)  300%   15.0     1,085     885     785     285     (15)  400%   20.0     1,480     1,280     1,180     680     380    

             *  Current  estimated  growth  rate                            Figure  3:  Impact  on  Amazon's  profit  given  a  customer  base  and  content  spending  per  year  

 

This   table   shows   that,   at   the   prospected   growth   rate,   Amazon   would   incur   in   losses   of   $300  

million  if  it  were  to  increase  its  level  of  spending  to  the  current  spending  level  of  Netflix  of  $400  

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million   per   year,   without   stealing   any   additional   customers   from   Netflix.   Under   static   market  

conditions,   Amazon  would   probably   have   no   incentive   to   change   the   status   quo  by   increasing  

their  on-‐line  streaming  catalog,  as  it  would  only  diminish  profits.    

In   order   to  model   a   game   under   today’s   conditions   we  made   a   series   of   other   assumptions/  

simplifications:    

• Both  Netflix  and  Amazon  have  access   to   the  same  content,  at   the  same  price   (this   is  a  

simplification,  as  Amazon  has  better   relationship  with  content  providers,  and,  given   its  

size  and  advantages  coming  from  the  retail  part  of  the  business,  is  likely  to  strike  better  

deals  with  content  providers)  

• Amazon  has  no  interest  in  expanding  to  a  DVD  mail  order  model  (the  only  overlap  with  

Netflix   would   be   if   Netflix   was   to   expand   to   Europe,   where   Amazon’s   Lovefilm   is  

operating)  

• EBIT   impact   for   Amazon   modeled   at   $79/user/yr   (Prime   fee)   +   $100/yr   (as   Prime  

customers  spends  3x  regular  customer)  –  we  hypothesize  than  the  $100/yr  EBIT  impact  

per   Prime   customer   already   takes   into   account   the   shipping   costs   that  Amazon  has   to  

incur  to  fulfill  the  customer’s  retail  orders    

• Fighting   scenario   for   Netflix   considered   at   $1bn   spending   on   content7,   as   price   for  

content  is  projected  to  increase  dramatically  in  the  near  future  

• Fighting  scenario  for  Amazon  considered  matching  Netflix’s  catalog  offer    

• The  game  is  played  only  by  Netflix  and  Amazon,  no  other  players  such  as  Hulu  or  Apple  

are  considered  for  the  moment  

• Payoffs  are  expressed  as  incremental  to  the  current  situation  

                                                                                                                         7  Equivalent  to  28%  drop  on  average  prices  for  current  number  of  subscribers  (e.g.,  $69/year  or  $5.75/month  for  streaming-‐only  plan)  Source:  Janney  Capital  Markets;  Morgan  Keegan;  Netflix  annual  reports;  Team  analysis  

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Under  these  simplified  assumptions  a  sequential  move  game  can  be  started.  As  the  decision  tree  

below   shows,   now   that   Amazon   has   decided   to   enter   the   OTT   market,   Netflix   can   choose  

whether  to  fight  (i.e.,   increase  its  spending  on  media  content  or  lower  prices)  or  accommodate  

and   remain   at   the   current   level.   Once   Netflix   has   chosen   its   move,   Amazon   can   answer   in   a  

similar  way,  i.e.  either  increase  its  spending  in  terms  of  content  or  stick  with  the  current  offer.  

Under  these  conditions,  the  following  decision  tree  can  be  drawn8:  

 

Figure  4:  Decision  tree  for  near  term  game  

Looking   forward   and   reasoning   backward   both   players   have   the   same   dominant   strategy   in  

choosing  “Accommodate”,  as  it  yields  higher  payoffs  for  both  independent  of  the  strategy  of  the  

opponent.    Considering  this,  Netflix  would  allow  Amazon  to  stay  at  its  current  level  of  spending  

and  forgo  $24  million  of  profits  by  accommodating,  while  Amazon  would  not  choose  to  increase  

                                                                                                                         8  Details  to  assumptions  and  calculations  used  to  model  the  payoffs  of  the  two  players  can  be  found  in  the  appendix  

Game  tree  for  near  term game EBIT  impact   (USD  mn)

Enter  on-‐line  streaming

Keep  out

Netflix  ups  catalog  investment  by  100%

Amazon  matches  Netflix’s  expanded  catalog

Amazon  matches  Netflix’s  current  catalog

-‐ $776mm

-‐ $345mm

+  $22mm

-‐ $250mm

+  $44mm

-‐ $24mm

-‐ $552mm

-‐ $240mm

+  $0mm

+  $0mm

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spending,  as  it  would  only  have  a  negative  impact  on  its  profits.    The  assumptions  to  this  game  

have   to  be  modified   though   if  we   take   into  account  a   longer-‐term  perspective,   in  which  more  

factors   should   be   accounted   for.     The   competitive   landscape   will   probably   undergo   several  

changes  over  the  next  few  years,  and  especially  for  Amazon,  things  might  look  different:    

• One  of  Amazon’s  core  businesses  (retailing  of  books)  will  increasingly  shift  from  physical  

to  digital.    Amazon  needs  to  hedge  this   loss   in  a  different  way,   i.e.  by  binding  its  Prime  

customer   base   through   convenience   and   being   successful   in   shifting   from   physical   to  

digital   content,   i.e.   building   up   reputation   as   a   predominant   player   also   compared   to  

established  incumbents  such  as  Apple  

• As   OTT9   is   rapidly   growing,   more   and   more   customers   are   deciding   in   favor   of   one  

provider  or  the  other.    The  more  Amazon  waits  in  being  an  aggressive  and  active  player  

in   this   market   and   in   updating   its   content   to   increase   the   customer   base,   the   more  

prospective  customers  might  choose  a  different  OTT  provider  and  hence  make  Prime  a  

less  effective  tool  in  gaining  new  customers  

• Content   providers   are   expected   to   gain   more   bargaining   power,   as   the   increasing  

number  of  providers  will  drive  prices  for  content  upwards.    Here  too,  the  later  Amazon  

strikes  deals  with  content  providers,  the  more  expensive  these  will  probably  be  

Given  this  set  of  considerations  we  assumed  that  Amazon’s  Prime  customer  base  will  grow  to  20  

million,  adding  to  the  assumptions/simplifications  we  described  for  the  near  term  game.  

In  this  case  the  decision  tree  looks  as  follows:  

                                                                                                                         9  Over-‐the-‐Top  video  

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Figure  5:  Decision  tree  for  longer  term  game  

Amazon   has   a   dominant   strategy   (see   table   below)   in   fighting   for   additional   customers,   and,  

considering   this,   Netflix   has   no   other   choice   but   to   fight   too.   This   is   resulting   in   higher  

incremental   profits   for   Amazon;   hence   it   is   possible   to   assume   that   the   game   will   develop  

towards  this  direction  in  the  near  future  

   Amazon              

   Accomodate   Fight      

Netflix  

Accomo-‐date    

$180         $1,690    ($96)       ($1,400)      

Fight       $90         $343    ($572)       ($1,055)      

             

    Dominant  strategy        

Figure  6:  Expected  payoff  table  for  longer  term  game  

 

 

Game  tree  for  longer   term game EBIT  impact   (USD  mn)

Enter  on-‐line  streaming

Keep  out

Netflix  ups  catalog  investment  by  100%

Amazon  matches  Netflix’s  expanded  catalog

Amazon  matches  Netflix’s  current  catalog

+$343mm

-‐ $1,055mm

+  $90mm

-‐ $572mm

+  $180mm

-‐ $96mm

+  $1,690mm

-‐ $1,400mm

+  $0mm

+  $0mm

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5. Other  issues  and  considerations  

Amazon’s  Prime  membership  offers  benefits   to  customers  above  and  beyond  movie  streaming  

hence  there  is  an  additional  factor  besides  content  that  should  be  taken  into  consideration  when  

thinking  about  churn:  when  offered  a  similar  content  for  the  same  price,  prospective  customers  

will   more   likely   choose   Amazon   instead   of   Netflix,   as   it   is   offering   more   value   for   the   same  

money.    Additionally,  given  its  strong  financial  position,  Amazon  does  not  need  to  make  money  

on  “streaming”   if   it  can  make  money  elsewhere  by  driving  people  to  Prime  (similar  to  the  case  

Microsoft   v.   Netscape   in   terms   of   browser   wars).   This   gives   Amazon   both   more   flexibility   in  

terms   of   the   pricing   decision,   as   well   as   a   stronger   negotiating   position   when   facing   content  

providers  (besides  being  already  partner  of  some  of  those  due  to  the  retailing  business,  whereas  

Netflix  is  seen  more  as  a  threat10).  

The  demand  for  DVDs   in  the  mail  will  persist,  even  as  demand  for  streaming  content  rises  and  

Netflix  clearly  owns  this  segment  of  the  market,  while  Amazon  doesn’t  appear  to  be  interested,  

as  it  has  tried  DVD  rentals  in  the  past  and  disabled  the  business,  and  currently  operates  only  in  

Europe   through   its   Lovefilm   company.     Netflix   has   hence   a   chance   to   add   value   to   customers  

through  bundling,  and  could  survive  in  the  future  with  this  business  alone.    Current  stock  prices  

however   could   not   be   maintained   and   it   would   also   shift   Netflix   from   a   high   growth   young  

industry  (OTT)  to  a  mature  and  declining  one  (DVD  rentals).  

 

6. Final  conclusions  and  recommendations  

From   the   simple   game  we   have   described   above,   following   conclusions   going   forward   can   be  

drawn  

                                                                                                                         10  Netflix  has  the  right  to  lend  or  rent  movies  once  it  purchased  first  the  DVD,  diminishing  profits  for  content  providers  as  they  are  selling  less  copies  of  the  same  movie  or  show  

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• Amazon  seems  to  be  the  player  with  the  better  positioning  and  should  use  the  current  

momentum  to  increase  its  title  catalog  while  licensing  prices  from  providers  are  still  low  

and  the  overall  user  base  for  OTT  is  growing  fast.    This  could  be  an  advantageous  selling  

point  when  promoting  the  Prime  offer  to  prospective  customer,  which  seems  to  be  one  

of  the  most  profitable  current  tools  of  the  online  retailer  

• Netflix  can  still  rely  on  the  first  mover  advantage  (e.g.  more  brand  recognition  for  online  

streaming/movies)   and   should   consider   either   reviewing   its   pricing   decision   or   invest  

heavily   in   content   expansion   in   order   to   increase   its   customer   base.     Should   it   fail   to  

reach   a   critical   mass   that   would   allow   it   to   access   more   expensive   (but   more   sought  

after)   content,   it   is   likely   that   it  will   be   pushed   out   of   the  market   by   stronger   players  

besides  Amazon,  such  as  Apple  or  Google  

• The  OTT  market   is   in   its  very  early  stages  and  a  successful  business  model   is  still   to  be  

found.     Both  Amazon   and  Netflix   should   closely  monitor  what   other   players   are   doing  

and  be  ready  to  adapt  quickly  or  respond  once  other  business  models  start  to  emerge.  

• The  attractiveness  of  operating  a   streaming  only  business   is  highly  questionable   in   the  

long  term.  

   

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7. Appendix  

Assumptions  and  model  for  near  term  game  

 

 

Assumptions  and  model  for  longer  term  game  

   

 

 

 

 

ASSUMPTIONSAmazon  Prime  Users 5,000,000 Additional  Annual  Growth  In  Prime  w/  Current  Content 5.0%Amazon  Prime  Price/Yr. $79.00 Additional  Annual  Growth  In  Prime  w/  Better  Content 50.0%Netflix  Users 20,000,000 Netflix  Loss  to  Amazon  w/  Current  Content 250,000Netflix  Users  On  Streaming  Only 33% Netflix  Loss  to  Amazon  w/  Better  Content 2,500,000Streaming  Only  Plan  Price/Mo. $7.99 Value  of  Prime  Customer  over  Normal  Customer  ($/Yr) $100.00Netflix  2012  Streaming  Content  Cost $1,000,000,000 Reduction  in  Switching  to  Amzn  if  Nflx  Lower  Price/Improve  Content 50%

Netflix  Price  Reduction  ($/month) $1.00

ASSUMPTIONSAmazon  Prime  Users 20,000,000 Additional  Annual  Growth  In  Prime  w/  Current  Content 5.0%Amazon  Prime  Price/Yr. $79.00 Additional  Annual  Growth  In  Prime  w/  Better  Content 75.0%Netflix  Users 20,000,000 Netflix  Loss  to  Amazon  w/  Current  Content 1,000,000Netflix  Users  On  Streaming  Only 33% Netflix  Loss  to  Amazon  w/  Better  Content 15,000,000Streaming  Only  Plan  Price/Mo. $7.99 Value  of  Prime  Customer  over  Normal  Customer  ($/Yr) $100.00Netflix  2012  Streaming  Content  Cost $1,000,000,000 Reduction  in  Switching  to  Amzn  if  Nflx  Lower  Price/Improve  Content 50%

Netflix  Price  Reduction  ($/month) $2.24