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Netflix is a company that needs no introduction. But just in case you are unaware of Netflix’s business model (because someone else is paying for your account), Netflix charges a monthly fee for your subscription and you get to watch unlimited TV shows and movies, and play mobile games.
In 2008, the company had fewer than 9M subscribers, but once it began offering video streaming directly to TV for existing customers, subscriber growth accelerated and it supported the introduction of a streaming-only service in 2010.
Netflix’s ability to spread the fixed costs of content, markets, and technology across a much larger subscriber base than any of its competitors is continually reinforced through superior customer service, a powerful recommendation engine, and an amazing, habit-forming product.
In contrast, traditional media aggregators, such as cable channels, act as wholesalers. Individual consumers, like you and I, are not their direct customers. Rather, they are selling to distributors who manage the distribution to individual households. As a result, they cannot form a relationship with individuals or benefit from feedback loops.
Netflix is the aggregator that manages the direct consumer relationship itself, allowing them to excel in customer service and to perfect its product by harnessing customer feedback.
The Truth About Why Netflix Went Into Content Creation: Competition
The dirty little secret of the media industry is that the content aggregators, not the content creators, harvest the bulk of the value created from the media industry. Unlike movie studios that produce the creative content, channels that aggregate old movies, cartoons, and TV shows generate much greater profit margins.
Why is that so? The reason is simply that the structure of content aggregators and distributors lends itself to competitive advantages – such as scale and customer captivity – that content creation does not.
House of Cards debuted in 2013 and it was a massive hit. Since then, the company has increasingly relied on original content. In 2016, it formally announced “a multi-year transition and evolution” toward having half the content on the service be original productions. And by 2018, the majority of new releases on Netflix were originals.
But why did Netflix pivot into creating originals when being a content aggregator would have been more profitable?
There’s only one reason for the most successful content aggregator to venture into content production: increasing competition.
In light of the threat from over-the-top (OTT) streaming services and diminished clout with distributors, cable channel owners are stepping up their investment in original content. As subscribers for cable declines, their profitability falls sharply as operating leverage is working against them.
The streaming war is intense with many players in the market, such as Apple TV+, Disney+, NBCUniversal’s Peacock, Paramount+, Amazon Prime Video, HBOMax (WarnerMedia), Hulu, CBS and Quibi. All of them are pouring in a ton of money and packed with celebrity-driven streaming content.
Reed Hastings, Netflix’s CEO, understood the threat early on, before its newly emerged competitors started to pull the plug on Netflix by removing their most prized licensed content such as Friends, all of Disney & Marvel movies and more.
With only a few years of experience in producing original television series under their belt, Netflix made a big decision to finance original films in 2015. This move made sense given that films have always had a disproportionate share of viewing on Pay TV.
It was a bold move, and the difference in skills and resources required was reflected in the fact that all the major studios historically maintained largely separate operations for each. And Netflix quickly went on to becoming potentially the single largest film studio, producing everything from art films to blockbusters across genres.
Using Data
Well before Netflix became a streaming service, when the company was a DVD rental company, it had already effectively used customer data to develop a powerful recommendation engine. There were two benefits:
First, by constantly offering DVDs that were most likely to be of interest, it increased customer satisfaction and reduced churn (number of users unsubscribing).
Secondly, since new releases are way more expensive, the company delights customers by recommending older titles that match their interests.
When it pivoted into streaming, there was an explosion of consumer data collected. Netflix knows which titles you hover over, whether you watch them, how you watch them, whether you pause, fast forward or never finish the shows. It even knows what device you’re watching on.
Netflix also runs countless A/B tests across its user base to perfect its recommendations and determine which trailers to show which user, and on which device. As Netflix describes it, there are as many customized “different versions of Netflix” as there are subscribers.
Apart from producing great content, the use of data to customize each user’s experience definitely led to stickiness of the service and Netflix having the lowest churn amongst its competitors.
First-Mover Advantage?
By being a first-mover in the streaming industry, Netflix had the opportunity to quickly gain scale. And the ability to quickly gain scale by being a first-mover is predicated by a relatively stable product-market fit and technology. Otherwise, customers are less likely to sign up or would churn aggressively after the promotional phase.
Which is why the winner in most markets comes from late entrants:
- Google over Yahoo
- Facebook over MySpace or Friendster
- Amazon over Ebay
Late entrants let the first movers undertake “free R&D” for them and only invest heavily once there is greater visibility of the size of the demand and technology requirements. It was Netflix’s ability to be nimble and creative that saved it from this fate, along with its willingness to admit mistakes and reverse course when needed.
Reed Hastings announced in 2011 that the company would no longer offer unlimited streaming with DVD rentals for $10 per month. Members will instead pay $7.99 for streaming or DVD rentals each. They will have to pay $15.98 for both, or a 60% price increase.
As a result, 800,000 terminated their service when they only had around 20M subscribers and the stock price plummeted 77%. Reed was willing to be embarrassed and reverse his earlier decision on splitting the services. Although he was right that DVD will eventually be phased out, the push back from subscribers indicated that he may have pulled the plug too early.
Throughout Netflix’s history, management has demonstrated a willingness to innovate, move fast and correct their actions when required. This allowed them to capitalize on their first-mover advantage, instead of letting late entrants seize market share.
High Fixed Costs Business
Early in my investing journey, I have always preferred businesses that are asset-light in nature. After all, this is a characteristic of a wonderful business, and a classic example is Buffett’s investment in Sees’ Candies.
But I have developed an appreciation for high fixed costs businesses that are able to scale.
In the past, a high fixed cost business like a retailer (also a frequently cited example by Buffett), will incur huge fixed costs in buying the land and building up the mall. And here’s the challenge, they could be running a highly successful mall, where their shoppers love them for the tenants selection and the ambience, but they are unable to scale beyond serving customers within its proximity.
As successful as they might be, the retailer will be capacity constrained (there’s a limit to how crowded it can be) and they are unable to reach customers beyond the city they are in (or have its services delivered internationally).
The benefit is that competitors are less likely to sprawl up near a successful mega retailer due to the high fixed costs. The risk of sinking large amounts of capital as a late-mover is high because of the competition for traffic and the retailer might have contracts requiring its popular tenants to not set up similar franchises in competing malls within its proximity for a couple of years.
On the other hand, a business like Netflix enjoys the benefit of high fixed costs from producing original content as a barrier but without the constraint of scale. Their original content is able to scale beyond borders and there’s no limit to the number of users they can serve.
Netflix as the dominant player can set the bar for competitive content high enough, such that the smaller players will have to keep burning cash to survive while it makes a good living.
Risks/ Bear Thesis
Highly Competitive Streaming Industry
The biggest risk for Netflix is competition in streaming. There are at least six well-capitalized competitors chasing after the same content, talent, and subscribers.
To continue maintaining its position as the dominant player, Netflix needs to continue reinvesting heavily into building its content library and continue experimenting with unproven content to find the next Squid Game or Stranger Things and keep its user base entertained.
That said, Netflix’s value proposition and execution has held up well, with its churn rate being the lowest amongst its competitors.
Competition for Attention
Also, Netflix isn’t just competing with other streaming companies. They are also competing with gaming companies, TikTok, Youtube, Instagram and even sleep for a share of your eyeball time.
For example, in 2017, CEO Reed Hastings shared “You get a show or a movie you’re really dying to watch, and you end up staying up late at night, so we actually compete with sleep,”, in their Q4 2018 earnings report “We compete with (and lose to) Fortnite more than HBO.” or in their Q2 2020 shareholder letter “TikTok’s growth is astounding, showing the fluidity of internet entertainment.”
Competition comes from all sides and Netflix will always have to be on their toes and fighting to deserve its customers’ share of wallet. In other words, this is not a business where any idiot can run and still survive, unlike Coca Cola, Disney or Microsoft which survived despite years of poor management.
Key Man Risk
This brings us to the next risk, key man risk. Reed Hastings has helped Netflix self-disrupt itself, pivot into streaming and maintained its dominant position despite so many well capitalized competitors entering the industry.
Limited Success In Entry to India
Last but not least, Netflix isn’t seeing success with penetration into India and has lowered prices. Management cited that India was a unique case because pay TV pricing is very low. In fact, Netflix performance in India is so bad it is the second least most downloaded app. Disney+ is the leading streaming service in India despite being a new entrant because it partnered with Hotstar and is sold at a much lower price point.
Management
Netflix’s culture has been a key reason why Netflix was able to excel. Reed Hastings strives to have the highest amount of talent density in Netflix, as he stated “Once you have high talent density in the workplace and have eliminated less-than-great performers, you’re ready to introduce a culture of candor.”
Netflix’s Culture
The culture is based on the idea that if you hire great employees, you can give them a tremendous amount of freedom. This empowers them to make good decisions, move quickly, and innovate.
His priority is to build a workplace that consists of stunning colleagues, or what he likes to call the “dream team”. Where team members feel safe to talk to superiors about any subject or that it is okay to make mistakes as long as they search for improvement afterwards.
Leaders are encouraged to ask themselves which employees they would fight hardest for. Do not waste resources on attempting to improve employee performance. Instead, fire the employee, give them a generous severance payment and be fully transparent to everyone about the decision to fire the employee.
“If you have a team of five stunning employees and two adequate ones, the adequate ones will sap managers’ energy, so they have less time for the top performers, reduce the quality of group discussions, lowering the team’s overall IQ, force others to develop ways to work around them, reducing efficiency, drive staff who seek excellence to quit, and show the team you accept mediocrity, thus multiplying the problem.” — Reed Hastings
High performers enjoy working with other high performers. And because of their transparency, communication and decisive action to ensure that they have the highest talent density, employees at Netflix have a very high approval rate for management.
There are many more tools in Reed Hastings arsenal to ensure that Netflix continues to innovate at a rapid pace. If you like to learn more, the book No Rules Rules: Netflix and the Culture of Reinvention by Reed Hastings and Erin Meyer is highly recommended. You can also view the highly regarded 129-slide deck Netflix put together in 2009, outlining the company’s culture. Sheryl Sandberg called it the most important document to emerge from Silicon Valley.
Skin in the game
Reed currently owns about 1.11% of Netflix valued at about $2B. He definitely has skin in the game and he actually bought the dip ($19M worth) when the company missed estimates in the most recent quarter. This was the first time he actually purchased Netflix stock from the open market.
Growth Opportunities
Large Total Addressable Market
Despite being the most dominant player, Netflix still has plenty of room to grow. As of today, there are about 222M Netflix subscribers. Excluding China, this amounts to about 25% of the 800M to 900M households with fixed broadband access or who subscribe to pay TV.
According to Statista, most Pay TV users pay north of 100USD a month, which can easily be replaced with a bundle of three to five streaming services per household. Cord cutting will continue to accelerate and there will be room for a few streaming services to take up this space.
Advertisement?
Netflix has long maintained a steadfast stance against advertising, largely because they want to optimize customer experience and make sure they are incentivized to produce only entertaining content, rather than cashing in on their customers’ attention with advertisements.
But in the recent Morgan Stanley Technology Conference, Spencer Neumann, the CFO of Netflix seems to indicate that the company might be open to advertisement in the future. When asked if Netflix would follow Disney+ footsteps and include a ad-supported tier, he replied:
“Now for us, it’s not like we have religion against advertising to be clear. I mean we’re — we said what we’re focused is on building, optimizing for long-term revenue, big profit pools. And we want to do it in a way that is a great experience for our members, great for — so we lean into consumer experience, consumer choice and what’s great for our creators and storytellers.
So if at some point, we determine something that we have the right to kind of player within the space and it meets those dimensions, then great. But that’s not something that’s in our plans right now. We think we have a great model in the subscription business. It scales globally really well. Again, we were about a $20 billion revenue business 2 years ago when we were here, $30 billion revenue now. You kind of kind of see how that’s pretty — the growth is healthy across every region of the world. So we have a really nice scalable subscription model, and again, never say never, but it’s not in our plan, but other folks are learning from it. So it’s hard for us to kind of ignore that others are doing it, but for now it doesn’t make sense for us.”
For many years, the company has relied on price increases and increase in the number of users to sustain its ever increasing content spend. While I believe there’s a lot more room for Netflix to further increase prices, introducing an ad-support tier with a cheaper monthly subscription could increase revenue and at the same time allow Netflix to onboard price sensitive consumers.
Furthermore, Netflix has been facing lackluster demand in India and had to lower their prices to acquire a larger market share. I believe India shares similar traits with China’s Video-on-Demand market. In China, there is a lack of willingness to pay and most offerings are ad based or even only semi-legal.
The most dominant players Tencent Video and iQiyi saw subscribers count stall after raising prices. Hence, services in those markets need to be subsidized by advertising dollars. In the same vein, I believe introducing an ad-support tier would help increase Netflix’s reach to more consumers.
Gaming
Netflix is also branching out into gaming and the company believes that its subscription model provides the company a unique advantage when it comes to gaming. Here is what its Chief Product Officer Greg Peters said in Netflix’s Q2 2021 earnings call:
“We also feel that our subscription model yields some opportunities to focus on a set of game experiences that are currently underserved by the sort of dominant monetization models and games. We don’t have to think about ads. We don’t have to think about in-game purchases or other monetization. We don’t have to think about per-title purchases. Really, we can do what we’ve been doing on the movie and series side, which is just hyper laser-focused on delivering the most entertaining game experiences that we can’t. So we’re finding that many game developers really like that concept and that focus and this idea of being able to put all of their creative energy into just great gameplay and not having to worry about those other considerations that they have typically had to trade off with just making compelling games. So those are some of the core things that we’re excited about and think that can make this effort for us special even in the world of games.”
Essentially, the company is confident that they are able to attract talented game developers and create much more entertaining games than currently what’s on the market. There are largely three ways to monetize digital games:
- You will first be sold the game, and then you will be enticed to keep spending more money by introducing DLCs or paying an ongoing fee to play multiplayer.
- The game is free, but to get gears or avatars, you will need to spend. Otherwise, you will lose out to competition or your experience will not be as fulfilling.
- The game is free and there’s no need to pay, but there will always be ads all over the game.
In order to find an equilibrium between getting users to spend more and retaining them, game developers pay special attention to human psychology. Users can be affected by this as they are required to keep paying more, otherwise they will not be able to fully enjoy the game.
Netflix’s objective will be different. Rather than milking gamers by getting them to spend more or increase ad revenue, they will seek to optimize for entertainment. Ensuring that their existing subscribers get the most entertainment value for the fixed subscription fee paid.
Operating Metrics
Paid net subscriber additions have increased steadily over the years, with 2020 being a bumper year due to COVID-19 lockdowns. For the full year 2021, net subscriber additions totaled 18M vs 37M in 2020. This was largely of the COVID-19 pull forward impact and the company should be evaluated on a two year rolling period, i.e. 55M additions from 2020 to 2021, or 27.5M per year.
And here is why the stock tumbled, management forecasted Q1’22 paid net additions of 2.5M vs 4.0M a year ago. Acquisition growth has not re-accelerated to pre-COVID levels possibly due to the continuing COVID overhang and macro-economic hardship in several parts of the world like LATAM.
Given that the potential addressable market of Netflix is 800-900M users, and this is expected to increase as more folks from emerging economies come online, the stock dropping more than 40% due to a slowdown in 2022 is likely Wall Street missing the forest for the trees.
Management is confident for operating margins to improve at 3% per year. It’s not going to be linear depending on when they begin certain heavy project spending, and for the next few quarters we can expect margins to dip as they resume spending on content which were delayed due to COVID-19 restrictions.
Operating leverage is evident from the rising margins. Despite growing content spend by 23% annually, the company has held content spend per subscriber constant. Meanwhile, Netflix has increased its subscription fee by 7% without experiencing massive churn, resulting in improved subscriber unit economics.
Netflix has improved its value proposition for its customers every year as its volume of original high-quality content has far outpaced price increases.
Take the United States and Canada (UCAN) region for example, subscribers are currently paying only $15.49 for $12.2B worth of content spend in 2021 alone whereas Disney+ & Hulu subscribers are paying $19.99 for $10.3B worth of content spend in 2021.
Just as a thought exercise, with 75.2M subscribers, if Netflix raised UCAN pricing to $19.99 without losing any customers, earnings will increase by $3.4B, from $5.1B to $8.5B. If that happens, its PE multiple will drop from 31.5x to 18.9x today.
Valuations
With streaming still having a long runway (800M to 900M households), we will assume that subscribers count will grow to 318M, or a 35% market share in 2026 and that they are able to continue raising prices at 4% annually to $169 per year (or $14.08 monthly), bringing them a revenue of $52.1B.
Assuming operating leverage kicks in and they command a 25% net income margin while holding total outstanding shares constant (they have announced a share buyback program but I’m just going to assume shares remain constant), EPS would come up to be $29.
Put on a 25x terminal PE multiple and the estimated share price would be $715 in 2026, an 15% IRR from today.
If you like to adjust the assumptions, feel free to save a copy of the spreadsheet here.
Conclusion
Netflix has come a long way since their DVD days and its management has always used data to drive their decisions. While new subscriber acquisitions seem to have slowed down, given the large and growing addressable market, coupled with the massive entertainment value they bring for a low price point, Mr. Market seems to have overreacted to the near term outlook for subscriber growth. That said, Netflix’s moat is growing as its content library grows with its subscribers count but it’s unlikely that the size of its moat will match Amazon’s or Google’s moat.
Disclaimer: This research reports constitute the author’s personal views only and are for educational purposes only. It is not to be construed as financial advice in any shape or form. From time to time, the author may hold positions in the below-mentioned stocks consistent with the views and opinions expressed in this article. Disclosure – I hold a position in Netflix at the time of publishing this article (this is a disclosure and NOT A RECOMMENDATION).