Why Netflix May Be the Future of Gaming

Is cloud gaming on Netflix the future of gaming?

When I was growing up, I received a $20 Apple gift card every Christmas. I was ecstatic - $20 enabled me to buy 20 songs at $0.99/song on iTunes. Fast forward 10 years and I now have over 2,000 songs downloaded on Spotify for just ~$10/month. How times have changed.

Just like Spotify disrupted the pay-per-song business model, Netflix is looking to disrupt the pay-per-game video-game business model. Netflix announced on Wednesday that it would reportedly offer video games within "the next year" at no extra cost. It would do so by ways of video game streaming.

In this analysis, we aim to understand the reasons why Netflix is getting into video game streaming, look at their competition and potential competitive advantages in hopes of uncovering some part of their long-term strategy.

Table of Contents:

How Video Game Streaming Works

Why Netflix Is Getting Into Video Games

  • Market Share Loss

  • Declining Returns on Content Spend

  • Limited Ability to Monetize Content

  • Why Netflix Needs Video Game Streaming

Competition in Video Game Streaming

Competitive Advantage & Predictions

How Video Game Streaming Works

Traditionally, playing video games requires three components: a physical (or digital) copy of the video game, a console on which to play and a screen. Video game streaming on the other hand, only requires a screen.

Video game streaming, also known as "cloud gaming", works by having another computer run the game for you. You provide the inputs, the computer runs the game and sends you back the images. Since another computer is running the game, your hardware doesn't matter — enabling you to play any game on any device capable of streaming a movie.

Why Netflix Is Getting Into Video Games

Loss of Market Share in Streaming

As competition within the video streaming space has grown, Netflix has been struggling to continually attract new subscribers. In Q1 2021, Netflix reported just under 4 million new subscribers, well below its guidance of 6 million and consensus expectations of 6.3 million. Management guided for just 1 million additional subscribers in Q2 2021, the lowest guidance since 2013.

While Netflix claimed in their Q1 2021 earnings press release that competition did not play a large role in their subscriber miss, market share data paints a different picture. Ampere Analysis, a media and content analytics firm, stated that Netflix dropped from 29% market share in 2019 to 20% in 2020.

Declining Returns on Content Spend

Netflix's content strategy is failing. As competitors all look to acquire rising talent and the licenses for the most popular TV shows, content spend has been increasing but returns of that spend, i.e. subscriber growth, has dropped. That is, Netflix is seeing declining returns on content spend. Without live content and a lack of additional verticals, Netflix is increasingly falling behind the likes of Disney and Amazon which can monetize additional verticals alongside their video streaming platforms.

Limited Ability to Monetize Content

In addition to Netflix's issues of decreasing market share and declining returns, Netflix also has a severe disadvantage: its limited ability to monetize content. With only one revenue stream, subscriber fees, it cannot multiply the revenue from a hit series like its competitors. For example, Disney monetizes its content by offering merchandise, creating theme parks, organizing cruises and more. As a result, Netflix is forced to burn cash in hopes of creating TV-hits that may attract new subscribers whereas Disney can monetize its past and current hits through a number of channels.

The disparity in monetization capability has put a stark contrast between Netflix and Disney, with Netflix burning $1 billion in free cash flow since Q2 2019, while Disney generated $4.7 billion in free cash flow. Over the last 5 years, Netflix has burned $11.7B in free cash flow.

Why Netflix Needs Cloud Gaming

Clearly, Netflix's current exclusive-content-focused strategy needs an overhaul: the company is quickly losing market share, seeing declining returns on content spend and burning through cash relative to its competitors. Hence video game streaming.

To say that the gaming industry is big would be an understatement. While exact numbers are not known, the gaming industry in the U.S. alone is worth over $65B, with U.S. consumers spending over $11B on video games in Q2 2020.

As such, cloud gaming presents a non-cannibalizing growth opportunity for a company which is struggling to find new verticals. The real challenge will be execution.

Competition in Video Game Streaming

While video game streaming might seem like a revolutionary idea, the space already has a lot of competition, none with great success. Critics argue that cloud gaming is bogged down by frustrating glitches and requires a strong local internet connection. Google's was the first big tech company to offer such a product. Google released its Stadia subscription service in November 2019 and was quickly criticized for poor performance and a scarcity of games.

Since then, a number of companies have attempted to put their spin on it. Console manufactures like Xbox and Playstation developed their own subscriptions, just like Amazon, Facebook and Google created their own platforms. The chip maker Nvidia also gave it a shot.

All in all, competition within the space is fierce. Without technical expertise in the space, Netflix may be doomed to fail. However, the company does have some competitive advantages over the likes of Google and Facebook.

Competitive Advantage & Predictions

The biggest weakness in Netflix's plan is the fact that it has no prior gaming experience. The company seems to be rectifying this issue with the recruitment of ex-Oculus and EA executive Mike Verdu, who may be their key in understanding the complicated video game market.

Beyond this issue however, there are some competitive advantages Netflix has over its competitors. For one, Netflix has tremendous experience providing high bitrate content to screens all around the world. Whether it be encoding algorithms or data structure, Netflix has tremendous most industry-knowledge when it comes to delivering high-quality, lag-free video around the world.

Additionally, Netflix also has a competitive advantage in its entertainment-specific penetration rate. As of 2020, 52% of adults in the U.S. had a current Netflix subscription (excluding all those who may have access to a subscription through friends or family). Unlike Amazon Prime, which majority of adults only have for the 2-day free shipping, Netflix subscriptions are specifically for entertainment. When someone opens Netflix they are looking for entertainment. This is not the case for Amazon, Facebook, or Google. In turn, this expectation creates an advantage for Netflix as it likely suggests that Netflix may have a higher adoption rate among its subscribers. Since you already have the Netflix subscription and are looking to be entertained, why not give cloud gaming a try?

Netflix's higher potential adoption rate in turn means that, either through word-of-mouth or press coverage, more individuals on the fence about a Netflix subscription may choose to subscribe, boosting their numbers. Additionally, Netflix Gaming would potentially disincentivize account-sharing as video game progress could only be saved to one account.

Lastly, Netflix's last competitive advantage is through its prevalence across TVs, consoles and more. These days, you'd be hard pressed to find a single modern TV and/or console that does not have Netflix installed. Unlike Stadia, Xbox Cloud or PS Now, which all require some sort of console to run, Netflix is already built-in to TVs and consoles around the world. This makes a consumer's adoption of video game streaming quick and simple relative to its competitors.

What do I personally think of the idea? Well, I expect that their release will be overshadowed by performance glitches and controversy surrounding the availability of games. While hiring Mike Verdu is a step in the right direction, I do not think Netflix has the industry knowledge required in order to make the amount of deals required to provide the selection of games that would appease gamers. That being said, I do not think that this is a problem without a solution. Over time, I expect Netflix's game library to get better. That being said, I would expect Netflix's adoption to be above that of its competitors. Regardless of what happens, I think it's a good attempt for Netflix to diversify its offerings. It signals to me that they've realized one of their biggest issues, their money-losing mono-channel streaming business and are looking for alternatives to grow subscribers. Only time will tell whether this comes true.