Netflix - A Growth Story Hitting Speed Bumps
A Growth Story
Netflix (NFLX) was founded in the early period of the Doc com bubble (1997). Inspired by Amazon's e-commerce model, the company launched as the world's first online DVD rental store. The company started to shift to a video-on-demand online streaming service at the beginning of 2007 by investing $40m to develop its own streaming platform called "Watch Now." Since then, the Netflix corporation strategy is to focus on content creation, user interface enhancement, and multi-platform adoption.
Since its online subscription streaming platform launched in 2007, NFLX has attracted over 192m paid memberships in over 190 countries. The company has had an average revenue growth rate of 30% a year and even delivered over $20B in revenue last year. While NFLX has negative cash flow due to front-end content license agreements and content investment, the company is still able to maintain a gross margin of 30%, with $1.2B in net income in 2018. Like many over the top peers(OTT), subscription growth is the catalyst for how well Netflix will perform in the coming years.
COVID acceleration
Netflix is one of the companies that has benefited from the COVID-19 (COVID) disruption. The company added 10.1m subscribers(sub) in Q2 2020, which is way above the management guidance of 7.5m. This increase was impressive, given that the company only generated 2.7m sub last year in the same quarter. The company also was able to deliver $899m in free cash flow (FCF), which is the 2nd consecutive quarter of positive FCF. And to add icing on the cake, the retention and churn have improved on a year-to-year basis due to newly acquired users during the lockdown period.
Needless to say, the Netflix business model is well-positioned to capitalize on the “shutdown effect” during the global pandemic. But they are not the only ones. Netflix’s media partners rolled out their own OTT (over-the-top) platform right before the COVID outbreak; Content giant Disney entered the space in late 2019, while Comcast, Werner media, and Apple followed. While COVID-19 indeed helped Netflix attract more sub and accelerated its revenue run rate, others have also benefited from this trend. Furthermore, the shift from retail to online entertainment has helped other streaming services catch-up with Netflix. For example, the Walt Disney studio released “Mulan” on their own OTT platform, Disney plus, with a combined membership offer or $30 for the film. This decision was monumental for the film industry; it marked the first time a major theatrical title was released on an OTT platform prior to its cinematic release. This presents a big challenge for Netflix. There are two major competing factors in the streaming model: user experience or interface (i.e software) and content generation. Netflix’s interface has always been the differentiator for the company, while its content production ability is weaker than other large movie studios with time tested IPs. Since COVID has closed the gap in terms of software front, which forces the company to invest in more original content, this could lead to more negative cash flow in the near term.
“In the first half of this year, we’ve added 26m paid memberships, nearly on par with the 28m we achieved in all of 2019. However, as we expected (and can be seen in the graph below), growth is slowing as consumers get through the initial shock of Covid and social restrictions.” - Netflix management on their Q2 earnings report
Short term Speed Bumps
We believe that Netflix is facing enormous near-term challenges from the following main factors: 1. Losing Competitive edge and 2. Content costs + delay.
Losing a competitive edge: Netflix is known for its steaming model, while other media giants focus on the cinema model. This landscape has changed dramatically over the past 12 months as more and more IPs owners have decided to launch their own streaming platforms. As a result, Netflix is starting to lose its exclusive streaming rights while they have only a few original contents under their name. This is a problem since IPs are the key to creating intangible value. Most notably, Walt Disney launched “Mulan,” to its streaming platform before releasing it in theaters, which means that more big studios would be likely to follow suit as COVID-19 continues to spread worldwide. Further, Disney recently announced that they will restructure their media and entertainment divisions and stick to a “Direct to consumer (DTC) strategy.” By doing so, Disney has separated content production from distribution, thus making the operation process more effective and eliminating conflict of interest with sole P&L. Conversely, Instead of showing signs of growth, Netflix seems to be entering a mature business stage. To put it into the words of Bloomberg’s Lucas Shaw: “But now that Netflix has transitioned from the upstart to the established power, it’s exercising more control over spending and behaving more like a traditional network. Studio chiefs, producers and agents all say Netflix is routinely outbid by Apple, Amazon and HBO Max.” Going forward, large studios’ DTC expansion will likely pose more challenges for Netflix to overcome in order to maintain its leadership position in the video streaming space.
Content cost + delay: Like its peers, Netflix would need to produce more content to attract and maintain more subscribers to its platform. While COVID-19 did bring more demand to the streaming model, it also disrupted production. Many countries were under lockdown, and film production as a whole is under restriction, given that close contact is required during filming, which violates social distancing rules. Production in a socially distant environment could be costly for studios due to stricter safety requirements and longer production time. Netflix has suggested 5%-15% cost increases compared to their pre-COVID levels. In their latest quarterly report, the company’s expenses associated with licensing and content production increased $201m in Q2, which was due to paused productions and pandemic expenses. Unlike other peers, Netflix has a tin original content library. They would need to produce enough quantity to generate a few titles that become popular. Since their few big titles would drive the most subscribers, these titles’ delays won’t have a material impact on Netflix’s sub growth as long as these titles are still on track with the production timeline. Unfortunately, the management expects that the paused production will lead to a second-half weighted content slate in terms of their big titles. As COVID-19 cases start to surge again, we believe the increase in production costs and delays will likely decelerate the company’s near-term sub-growth.
Quarterly Outlook + Valuation
While Q2 was an excellent quarter for Netflix, the management guided a 2.5m sub for the third quarter, which is way below the consensus of 5.3m. The company management explained that this low sub number will be driven by pulled forward demand from the second half of 2020, subtracting the positive impact of their popular series like Stranger Things and Money Heist. Most recently, Netflix was in hot water after the release of a French drama, “Cuties,” which caused a temporary spike in cancellation interest. As we tracked app data on Sensor tower, Q3 worldwide mobile downloads were flat while its down 3% in the US. When compared to the prior quarter, worldwide and US app downloads were down 23% and16% respectively. Additionally, the web traffic was down 13% from Aug to Sept. Even though management forecasted 2.5m sub for Q3, we don’t think this is a conservative call or a set up for an upside surprise for the quarter.
Netflix U.S. monthly churn - ANTENNA’s September churn data shows U.S. Netflix churn up significantly to a monthly rate of 5.77%. This compares to a read of 2.86% in August of 2020 and 3.10% in September 2019.
While traditional media peers are closing the gap, Netflix is still the streaming space leader, with greater potential for international expansion on the horizon. Once the pandemic effect decreases over time, the company can resume its content production in scale and normal sub growth. However, in the short term, especially in the coming two quarters, Netflix has several difficulties to overcome. In terms of valuation, the company is trading at 58x 2021 P/E, which is higher than Disney’s 37.5x; On EV/EBITDA bases, it’s 40x vs. 23x respectively in 2021. While it is true that Netflix has three times as many subscribers as Disney, it still won’t justify a massive difference in the forward multiple, given that Disney’s other business segments (cruise lines, theme parks, hotels) will likely recover in 2021. We have a relative contrarian take on Netflix’s Q3 and Q4 earnings report. While sell-side average PO for NFLX is about $600 per share, our DCF target comes out to be about $465 (WACC 10%, and growth 3%), with a Blue sky case of $530 and a Grey sky of $350 per share. *
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