Back in January, Netflix (NASDAQ:NFLX) expanded to 130 new countries, reaching every major country in the world except for China. At the time, Netflix declared that it was in "no hurry" to enter China, which has over 720 million internet users -- more than double the population of the United States.
During a conference call in January, Netflix CEO Reed Hastings stated that when it comes to China, the company should "be very patient and continue to build those relationships and listen and learn." During a recent media event in Seoul, Netflix Chief Content Officer Ted Sarandos called China "a great opportunity," and said that the company was still looking for ways to enter the market. Recent reports suggest that Netflix is looking for a local partner in China, but no companies have been named yet.
Why China is so challenging
Netflix's flagship show, House of Cards, entered China via a streaming partnership with Sohu (NASDAQ:SOHU) two years ago. The show quickly became the top American show streamed on Sohu, but those royalties were paltry compared to the monthly fees Netflix could have generated from individual subscribers.
The first main obstacle for Netflix in China is censorship. TV shows and movies in China can be censored for a wide variety of reasons, including the inclusion of violence, sex, religious themes, and political messages. These bans seem flexible and subjective, since House of Cards was approved despite its MA rating in the United States. Some industry observers believe that the show's depiction of the U.S. government as a cesspool of corruption helped it clear censors and gain such a huge following in China. But the fate of Netflix's other U.S. shows is unclear, since Chinese broadcasters and streaming services can't dedicate more than 30% of their programming to foreign content.
This means that to grow its business in China, Netflix needs to produce high-quality original programs in Chinese, just as it's doing with original programs in South Korea, India, and other major markets.
The second big problem is competition. Chinese Internet companies recognized the potential of streaming video years ago, and the market is saturated with players like Tencent Video, Baidu's (NASDAQ:BIDU) iQiyi, and Youku Tudou (UNKNOWN:YOKU.DL). These companies have all started producing original programs to lock in paid subscribers, which represents a big shift from the ad-based models many services previously relied on. London-based Mubi also recently entered China via a joint venture, beating Netflix to the punch as the first foreign streaming player in the market.
The fierce competition has boosted demand for better perks and lower prices. Tencent Video, which recently gained access to 600 live NBA games, costs just $4.50 per month, or $40 per year. iQiyi, which quadrupled its paid user base to 20 million over the past year, offers its members tickets to special events where they can meet their favorite stars. But in that costly battle for subscribers, most of China's top streaming sites have never posted profits.
So if Netflix wants to compete in China, it must boost its spending and lower its fees. But that would cause its operating margin -- which already fell from 6.2% to 2.5% between the first quarters of 2015 and 2016 -- to decline even further.
Netflix should focus on other markets first
Hastings is right about Netflix needing to adopt a patient approach to China. Charging straight into this cutthroat market without a solid localized expansion plan would inevitably result in big losses.
But if Netflix first observes its progress in nearby markets like Taiwan, South Korea, and Japan, it could gain better insights into the viewing habits of Asian viewers, which could give it an edge when it finally expands into China. For now, Netflix should focus on building its brand in countries with more lenient regulations and less direct competition.
Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Baidu and Netflix. The Motley Fool recommends Sohu.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.