The spectacular rise of Netflix is a textbook example of evolution and disruption done right. The sizeable growth runway is highly encouraging but questions around generating free cash flow loom large…
Netflix, a subscription driven Video-On-Demand (VOD) platform, is widely perceived as the gold standard in VOD content. It boasts of some extremely well-acclaimed and well received exclusives or originals such as House of Cards, Narcos, Stranger Things, Orange is the New Black, Sacred Games among a plethora of others. Global subscriber count nearing 125mn (up from sub 30mn in 2012) validates the quality of content and a 4000%+ return on the stock (since 2010 beginning alone) is a nice nod of approval from Wall Street. The catchphrase often used to characterize the times we are living in - “golden age of TV” or “golden age of content” is at least partly driven by the swashbuckling growth and disruption orchestrated by Netflix.
Netflix, came into existence as a DVD rental-by-mail firm and over the last two decades has evolved into a global video streaming powerhouse, accounting for about a third of overall downstream internet traffic across North America – a truly remarkable evolution.
The company's performance vs. other US Media majors is reflected in its share price outperformance over the last five years.
Note: These stock prices are normalized and represent a growth in $1 investment over the selected time period.
‘Original’ Content – The Real Growth Lever
An anecdotal view is that original or exclusive programming drives subscriber growth whereas a robust content library helps mitigate churn. It’s a view that I fully subscribe to and a closer look at the strategies adopted by Netflix (and also several other VOD platforms) fully endorses the value of original programming in catalyzing subscriber growth. As highlighted in my previous post, Netflix is expected to spend around $7.5-$8 billion (P&L basis) on video content in 2018 (globally), up sharply from $4.9 billion in 2016 and $6 billion in 2017.
If there is one thing to learn from Netflix’s stunning rise – it is the tactical awareness to spot the need for original and exclusives to drive growth, fairly early on. In my view this has allowed the company to defend its positioning despite studios pulling content out of Netflix to strengthen their own direct-to-subscriber OTT strategies. The best example is Disney who are scheduled to pull out content from Netflix beginning 2019 and focus on their own Disney branded VOD platform. However, Netflix appears to be well-positioned to offset and replace third-party content (such as from Disney) with originals, doing little to dampen the overall value proposition to the end-customer and in-turn continue to drive growth across newer geographies such as India.
Thoughts on recent Q2/18 earnings and the subsequent sell off...
While the purpose of this article is not to get into nuances of stock price movements or highlight trading strategies, it is still worthwhile to briefly address the recent downswing in Netflix’s share price following Q2/18 results (on July 16th 2018) just because of the sheer magnitude of Wall Street attention that Netflix garners.
The company reported healthy YoY growth in Q2/18 across key line items (revenue, margins and profitability), however it fell short on subscriber loading vs Wall Street expectations (and more importantly its own expectations). This, in my view, was the single biggest concern for investors setting alarm bells off across Wall Street, with many perceiving the quarterly results as the beginning of an elongated period of sluggish subscriber growth. This caused the stock to fall nearly 14% in afterhours trading but somewhat stabilizing through the day and closing about 5% lower (still a meaningful sell-off). What this highlights is the heightened investor focus on ‘subscriber progression’. In my view, this may well be one of the most watched metric across the Street for the next few quarters (perhaps Facebook’s MAU’s being the other). The theme is same though – focus on subscriber/user growth.
Netflix in its nascence in India; plenty of room for growth
Notwithstanding paid subscribers of nearly 125mn across the globe, Netflix’s penetration in India is still in its nascence. While it does not report subscribers by geography, industry estimates suggest India subscriber count in the paltry 1 million range. Although Netflix India has a rich (a subjective characterization admittedly) library of Hollywood and Bollywood titles and several TV shows, Netflix is aggressively deepening its roots into the mobile-first Indian market with increasing focus on local content (securing deals with Shah Rukh Khan’s Red Chillies Entertainment and Viacom 18 in addition to the recently launched high-profile TV series Sacred Games are all case-in-point examples).
With prices ranging from a lofty INR500 per month (for one screen in Standard definition) and INR800 per month (for four screens and High Definition/Ultra High Definition), Netflix is clearly not in an aggressive ‘customer-grab’ play at the expense of margin dilution. India is a long-game, and loading up on low Average Revenue Per User (ARPU) subscribers to gain a few points of growth, in my view is not a compelling long-term strategy.
First, discounted prices would set a sticky pricing anchor which might not be as easy to reverse in the future. Netflix already has invaluable experience in the US market on this front from their price raising experiment a few years back in 2016 which backfired with a corresponding unexpected jump in churn, and I would argue such an experiment in the Indian market at such an early stage could have severer ramifications in a more price-sensitive environment.
Second, margin dilution does not bode well for the stock. The stock trades on growth and margin expectations, and while the growth story can be realized through international markets (including India) where the runway appears to be long even at current price points, margin pressure will most certainly drive re-rating in trading multiples specially when the respective weight of emerging markets (or Indian) subscribes starts to build up on the consolidated subscriber base and starts showing up in operating margins.
Third, in my view, ‘quality content comes at a price’ and ‘price signals quality’ are theoretical ideologies that might resonate well in the Indian market, especially because Netflix is increasingly being viewed as not just a content platform but a lifestyle choice and there is certainly a level of status symbolization embedded in it.
The double-edged sword - will investments in content ever ease?
For Netflix to thrive, like any other company, it has to impress both – Customers and Shareholders.
Impressing customers requires a steady and unceasing supply of high quality content without a hefty jump in price points. A daunting task in its own right but Netflix’s historical success, credentializes its ability to do so in future.
However, impressing shareholders, is a more precarious endeavor. It’s one that I suspect will become progressively more intricate. In addition to subscriber growth, shareholders will eventually start wondering when Netflix starts to generate free cash flow (a fundamental metric used to value any business representing the operating cash flow that a business generates, less the cash outflow on purchase of assets. In Netflix’s case, purchase of assets means investments in content). Recall, Netflix doesn’t generate any free cash flow. In fact, in under a minute of browsing on their website, you find the below:
“We currently expect to generate free cash flow of approximately -$3 to -$4 billion in 2018. Beyond 2018, with continued success, we will invest more in originals, which would continue to weigh on FCF, even after we achieve material global profitability. As a result, we anticipate being free cash flow negative for many years.”
What makes the aforementioned question complicated is the fact that without content investments, it’s inconceivable to generate new content without which subscriber growth is nothing but a preposterous ambition. But shareholders see content investments as a double-edged sword, one which enhances Netflix’s value proposition and in turn drives subscriber growth BUT also the biggest drag on free cash flow. This leads to - when will this never-ending cycle of content investment taper off or if it ever will? Not an easy question to answer!
I believe, Netflix will (and so I think it should) continue to focus on growing its subscriber base (via investing in content of course) and hope that the rate of resulting growth in operating profit outpaces the rate of growth in content investments over the longer term. For even the stock to work, that ought to happen. Unless that happens, in my view, Netflix will find it difficult to reverse the cash burn and start generating free cash. If you raise prices or stop investing in content, notwithstanding an incredible content library, consumer economics (and history) teaches you that churn will show up in some shape or form. Act of balancing these two opposing forces to address the free cash flow conundrum, I suspect, is going to be the theme for the next few years. As of now, I believe Netflix management (and shareholders) find it fairly intuitive to trade off a point in free cash margin for a point in profitability growth. How long this tradeoff will be sustainable, time will tell.
Next week I will do a deep-dive into Amazon Prime Video. Stay tuned.