Netflix’s System Architecture Represents A Rare Competitive Edge

Netflix (NFLX) is the only major streamer to build out its content delivery network infrastructure. Netflix has invested roughly $1B over the past decade in a once-secret project called Open Connect that is proving to provide long-term strategic value to the company’s balance sheet. 

What Is a Content Delivery Network?

In short, content delivery networks (CDNs) are the mojo that fuels all streaming TV services. To understand the need for CDNs, let's begin with the fundamental concept that data requires time to traverse distances. Even with the speed of optical fiber, it still takes approximately 100 milliseconds for data to complete a roundtrip between Los Angeles and London. Now, imagine a scenario where thousands of users in London are trying to simultaneously stream the same movie and the movie is stored on a server in Los Angeles. The delay in content delivery under these circumstances would be quite substantial.

While there's a physical limit to how fast data can travel, there's a solution: we can position content on the edge—closer to the end users. Similar to the real estate industry, CDNs are all about location. By distributing content across a network of servers geographically dispersed worldwide, the latency in content delivery is significantly minimized.

Here's how it operates: Streaming platforms deliver their content to CDN providers for hosting. These CDN providers then replicate the content across a collection of servers located in various countries and within different Internet Service Provider (ISP) networks.

The majority of streaming services lack their in-house delivery infrastructure and, instead, depend on third-party content delivery networks. Established media streaming platforms like Disney, (HBO) Max, and others face the challenge of accommodating their ever-growing subscriber base, and they achieve this by partnering with external CDN providers such as Akamai, Lumen, Edgio, AWS CloudFront, and Fastly to distribute their video content.

However, Netflix stands out due to its distinctive approach. Unlike its peers, Netflix has made a substantial capital investment to establish its own CDN, consisting of over 17,000 servers strategically spread across 158 countries. This network is uniquely designed to bring content physically closer to end users, ensuring efficient content delivery. Netflix has been quietly pouring a mountain of cash into its CDN infrastructure called Open Connect for nearly a decade and is now positioned to reap the rewards.

The Economic Benefits of Building a Custom CDN

CDNs represent the largest variable operating cost associated with technology for most major streaming platforms. Third-party CDNs charge streamers based on the consumption of bandwidth in terabytes (TB). Thus, these operating fees scale with subscriber growth and are often built into average margin-per-user economics. 

These operating costs are ballooning due to TV manufacturers' never-ending hunger to roll out advancements in picture-video quality. Most major streamers have skyrocketed from Full HD (1080p) to 4K (2160p) over the past few years. The burden of offering higher resolutions falls upon each streamer's CDN infrastructure and there is no doubt that consumer demand for 8K is on the horizon as streamers are pressured to keep pace with new TVs flying off the shelves at Best Buy. 

Mouser Electronics, Chart Source

Netflix touts Open Connect as a vital part of its strategy for maintaining a high-quality streaming experience and retaining subscribers. Owning (as opposed to renting) its infrastructure protects the streamer consumption-based agreements with external CDNs which inherently protects Netflix against ballooning variable technology costs and facilitates global expansion for its subscriber base. 

Open Connect is one of many reasons legacy streamers are having difficulty catching up to Netflix’s Operating Margin, which currently hovers at 17.5%, with roughly 238M global subscribers.

NETFLIX, MacroTrends

For comparison’s sake, Disney+’s Operating Margin is sitting at 5%, with approximately 146M global subscribers. 

DISNEY+, Macrotrends

There are a lot of factors that play into Netflix’s operating margin advantage, but it’s important to understand that competitors face a major hurdle in replicating Netflix’s efficiencies associated with its Open Connect infrastructure.

CDNs’ Role in Subscriber Retention

Reliability, the bedrock of a quality CDN, is a major concern for streaming platforms as it directly correlates to a reduction in churn rates. When many of us launch our preferred streaming platforms, we frequently encounter frustrating issues. These issues include buffering, unresponsive controls, or even complete service outages. While these problems are far from ideal, they have become widely accepted as the occasional drawbacks of transitioning away from traditional cable television.

For instance, Disney+ experienced a crash on its very first day due to overwhelming demand, and it struggled again when the demand surged for WandaVision. HBO Max's app was so plagued with fundamental issues that even its leadership publicly acknowledged its subpar state.

The industry has been chasing Netflix’s churn rate for years, and its unique system architecture is a major reason why no competitor has managed to catch up.

ANTENNA Q1 2021 Growth Report

Despite the industry’s woes, outages on Netflix are few and far between and the streaming service has garnered a reputation for reliability. Netflix can achieve this because its Open Connect infrastructure is exclusive to the service, unlike third-party CDNs that cater to a hornet’s nest of customers. 

Long-term Competitive Advantage

Netflix's approach and infrastructure set it apart in the competitive streaming industry, making it challenging for other players to replicate. During its growth era, Netflix had the foresight to allocate over $1B+ in capital expenditures over a decade to build out a CDN infrastructure that rivals the geographic footprint of Google/YouTube.

The heyday of growth-oriented investing in the streaming sector is over, and it will be difficult for a legacy streamer to rally the CapEx and time investment required to launch an in-house CDN that can replace an external service like Akamai (AKAM). Furthermore, a migration of this magnitude would likely result in a short-term reduction in reliability which could spike churn rates for competitors that already have built a critical mass of subscribers. All of the above is a tough sell for public market streamers who are under pressure to hit quarterly subscriber forecasts. 

The foresight to build this competitive moat nearly a decade ago should prove to be a long-term competitive differentiator to Netflix’s value prop and balance sheet. Netflix’s “build” instead of “buy” approach is a major reason competitors continue to chase the streaming giant’s success metrics, including its best-in-class operating margin and churn rate. 

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Netflix, which can trace its roots back to a DVD-by-mail rental business model, has mostly blazed its own trail through what was - and in some ways still is - the undiscovered territory that is the streaming video market. But how will Netflix do with its recent move into the gaming space? Aaron Jacobson of Zollpa Games explores the implications for the mega streamer.

31 Jan 2024