Netflix, price discrimination, and the Goldilocks zone

Hiroo Onoda was an intelligence officer in the Japanese Imperial Army stationed in the Philippines during World War 2. Onodo was informed that Japan had surrendered through leaflets that had been dropped onto the island, but he and his fellow soldiers ignored them, believing that they were Allied propaganda. The Japanese government became aware of Onoda’s presence on the island and, in March 1974, his former commanding officer traveled to him and relieved him of all duties.

Some streaming services appear to be fighting a war that has already ended. Netflix revealed in its Q4 earnings report last week that it has accomplished something perhaps more important than subscriber growth: ARPU growth. For the first time, Netflix saw its ARPU in the UCAN (United States + Canada) reporting region exceed the level at which it sat before the advertising-supported tier was introduced in November 2022. As I argue in my Netflix Q4 earnings analysis, this ARPU growth offsets the ARPU decline imposed by the advertising tier. I argue that ARPU growth was realized through the successful implementation of price discrimination, achieved through a combination of three tactics:

• The password-sharing crackdown, which monetized freeloaders;
• Tier elimination, with the Basic tier being removed as an option for new users in Q3 2023 and being retired altogether over 2024, starting with Canada and the UK in Q1;
• Strategic pricing: the Premium and Basic tiers both saw price increases in Q3 2023 (the Basic tier was discontinued for new account creation but existing subscribers were able to maintain it).

The consumer pricing calculus now presents users with a more streamlined and monetarily compelling choice: the ad-supported experience for $6.99 per month, or more premium options that include the ability to share passwords. Netflix has noted previously that its Standard with ads generates higher ARPU in the US than its Standard tier, implying at least $8.51 in advertising ARPU per month.

Earlier this month, Netflix disclosed that the ad-supported tier is now comprised of 23MM MAU, up from the 15MM that the company confirmed in November 2023 (which was up from 5MM announced in May 2023). The company also noted at the time that 85% of the ad-supported tier’s subscribers stream for more than 2 hours per day. Netflix introduced 10-, 20-, and 60-second ad placements in November 2023, having launched the advertising tier with just 15- and 30-second placements, and the ad-supported tier’s FAQ states that users can expect to see four minutes of ads per hour, on average. Using some assumptions about the placement mix in the ad load, I estimate that the company serves roughly 11 ads per content hour, or 22 per user day at a two-hour user average stream time. If the US share of advertising MAU is 70%, the company is serving roughly 10.4BN ad impressions per month in the US. In July, the Wall Street Journal reported that Netflix had reduced the CPM it is asking from brands, to $39-45. Netflix had originally sought a $65 CPM ahead of the ad-supported tier’s launch.

So although Netflix was forced to reduce the CPM it charges advertisers — as I asserted that it would when the ad-supported tier first launched — the company has managed to achieve ARPU growth through a combination of tier streamlining, price increases, and freeloader monetization (accomplished through password crackdowns and the significantly cheaper, ad-supported tier). And that ARPU growth coincides with subscriber base growth: Netflix returned to subscriber growth in UCAN in Q4 2022, the quarter in which its advertising tier was introduced, and it returned to ARPU growth in the same region in Q3 2023, when prices were raised on the Basic and Premium tiers. Netflix’s post-advertising ARPU declines were not a drag on the company’s commercial fortunes as they were offset by disproportionate growth in subscribers.

The dynamic at play in Netflix’s growth is fundamentally a function of price discrimination, as I proposed in Ads in streaming, differential pricing, and the pursuit of ARPU:

This approach, by definition, can’t improve ARPU: while it will almost certainly boost overall subscription numbers, it will add net new subscribers at a lower price point (and potentially cannibalize some existing premium subscribers), reducing overall ARPU. This isn’t a bad strategy on its own, but it has to be considered in the broader scope of the streaming market. Disney is pursuing increased revenue with a deliberate attempt to grow ARPU that very likely won’t result in net new subscribers; Netflix is pursuing increased revenue with a deliberate attempt to grow its subscriber base that will decrease ARPU.

Netflix’s advertising tier is certainly growing quickly — it saw 70% sequential growth in both Q3 and Q4 — but as Netflix points out in its investor letter, it still represents 40% of new subscriptions where available. The 60% of subscriptions represented by the Premium and Standard tiers are important: the price of the Premium tier was increased in Q3. So a majority of new users are still not selecting the ad-supported tier, they’re paying more for the Premium tier than they were before the introduction of the ad-supported tier, and they are also potentially paying $7.99 each for extra seats for the Standard and Premium tiers.

Netflix seems to have settled into a Goldilocks zone across scale, pricing, and catalog management strategy at a time when its competitors are faltering. Netflix’s acquisition of the streaming rights for WWE’s Raw program was widely reported, but that same week, news of Netflix’s acquisition of the streaming rights for Warner Bros. Discovery’s Sex and the City surfaced. Warner Bros. Discovery broke with longstanding precedent last summer when it licensed a basket of series to Netflix in 2023, including Band of Brothers and The Pacific. Warner Bros. operates its own streaming service, Max, the core competitive positioning of which has always been tethered to Warner Bros.’ expansive catalog of IP. The company stated as much explicitly in its most recent earnings call:

One of the big advantages we have at Warner Bros. Discovery is that we own and control all of our content and storytelling IP and that allows us to distribute it in ways that maximize reach and profitability. Of course, the top priority for us is our streaming service Max.

This seems less than obvious as Warner Bros. Discovery licenses popular shows to Netflix. And while Max saw ARPU in the US increase both sequentially and on a year-over-year basis in Q3 2023, its domestic subscriber base declined by 2.6% and 1.9%, respectively.

Disney has also experienced a change of heart concerning licensing content to Netflix. Bob Iger, Disney’s CEO, revealed after the company’s last earnings call that it would augment the catalog of titles that it licenses to Netflix. Disney’s streaming business lost $400MM in its Q4 2023 (reported in November 2023), down from $1.5BN in Q4 2022 but nonetheless substantial, and with the trend seemingly approaching an asymptote.

The television series Suits broke Nielsen’s all-time overall streaming record when it appeared on Netflix last summer, licensed from NBCUniversal, the operator of the Peacock streaming service. Peacock’s revenue exceeded $1BN for the first time in Q4 2023, with its subscriber base growing by roughly 11% sequentially. But the streaming service lost “around” $2.75BN in 2023. Somewhat infamously, last May, the company acquired the exclusive rights to air the Kansas City Chiefs vs. Miami Dolphins game that took place on January 13th, 2024 from the NFL for $110MM. Streaming analytics company Antenna estimates that Peacock amassed 2.8MM new subscriptions over the wild-card weekend, which it describes as the “single biggest subscriber acquisition moment ever measured.” The profitability of this deal is dubious: ahead of the game, Peacock offered a roughly 50% discount on new annual subscriptions to its ad-supported tier, Peacock Premium. These discounted plans cost $29.99 versus $59.99 annually without the discount. Monthly, non-discounted subscriptions to Peacock Premium costs $5.99. Assuming that substantially all net new subscriptions related to the game were for the cheaper, ad-supported tier, and not accounting for advertising revenue, Peacock would need to keep those 2.8MM accounts subscribed for more than 6 months to recover its $110MM outlay for the game.

Netflix’s Q4 result, as well as the changing industry dynamics related to licensing, suggest that Netflix may have forced its competitors to either license their core IP assets to it or to embrace an unprofitable arms race for content acquisition. Netflix generated $1.7BN in operating profit in Q4 2023 and $10.3BN for the full year; Netflix can afford to acquire content from the other services that are all struggling to curb operating losses.

This is a risky proposition for those services. Netflix has achieved both ARPU and subscriber growth in a price discrimination strategy that combines initiatives across pricing, advertising, and freeloader monetization. This provides Netflix with content investment freedom that could ultimately create a virtuous circle. And Netflix has other monetization opportunities that the other streaming services don’t: namely, games, which I believe Netflix may use to expand its advertising business. Content licensing may prove to be an exercise in “eating the seed corn” for Netflix’s competitors: Netflix can monetize their IP better than they can, growing its subscriber base while investing in content adjacencies that it may ultimately monetize for further advantage.