April 20, 2022
Netflix’s (NASDAQ: NFLX) first-quarter 2022 earnings release sent the stock down roughly 25%. Perhaps the opening line of the company’s shareholders’ letter captures the “what happened” well:
“Our revenue growth has slowed considerably as our results and forecast below show.”
This was the first quarter in a long time when the streaming juggernaut failed to report a net growth in subscribers. The company’s global net paid subscribers went backward on a quarter-over-quarter basis by around 200,000. But that was just the tip of the iceberg, if I may say so. Netflix is guiding its subscriber count to decrease by 2 million next quarter!
Again, the shareholders’ letter does an excellent job of explaining what is happening:
“… our relatively high household penetration – when including the large number of households sharing accounts – combined with competition, is creating revenue growth headwinds. The big COVID boost to streaming obscured the picture until recently.”
In the late 1990s, my doctoral advisor and his colleagues had an army of students (including yours truly) working on some really cool problems in the Internet-on-demand streaming space. We had the pleasure of developing some state-of-the-art streaming protocols back in the day. We had answers to some of the pressing challenges then: lossy Internet connections, low bandwidth, challenges with scaling to millions of concurrent high-bandwidth streams, etc. The big question mark for anyone dreaming of a video-on-demand startup was access to content, which was locked up with studios.
Alongside academics, IBM (NYSE: IBM) Research Laboratories were active in the technology space producing high-quality research work.
But when it came to putting on a real-world trial, it came down to Time Warner, who ran one in Orlando back in the mid-1990s. It was what I call a technological success but a commercial failure. It was shuttered in 1997.
Netflix, also founded in 1997, was busy shipping DVDs to customers with orders placed online.
Netflix started streaming via a limited catalog in 2007. It was early days. Broadband penetration was in its early innings. The promise of on-demand content supplanting linear television was always there. It is a more desirable format in many ways, with the convenience of watching content, even binge-watching, perhaps at the forefront.
Netflix got a headstart. Studios didn’t see the Internet as a threat and were happy to find another avenue to monetize their content.
Netflix was very early in the game. Its only meaningful competition for many years was Amazon’s Prime Video service. Reed Hastings, Netflix’s co-CEO and co-founder, has always spoken of competition for eyeballs and our time. That was true then as it is now. But there was no real competition in the on-demand video streaming arena for almost a decade.
As Netflix started winning share from the cable television industry, Netflix knew that acquiring content would become harder at some point. It ventured into producing original content. That pivot happened around 2012.
There still wasn’t any meaningful competition.
Netflix spent money like a drunk sailor on building a content library. The content budget was effectively the sales & marketing budget. Great shows meant a horde of subscribers. The net result, however, was the lack of free cash flow. While the company posted GAAP profits, it hardly ever generated positive free cash flow.
The idea was to spend up the cash to grab as many eyeballs as possible. Then, at scale, I guess, it was hoped that content costs would amortize over a huge base and potentially allow significant free cash flow generation.
So continued Netflix’s march from 50 million to 100 million and then onto 200 million subscribers worldwide. There still remained a long runway for acquiring subscribers.
From 2007 to 2019 or so, Netflix had the field to itself. Then a flurry of services launched. Disney’s (NYSE: DIS) streaming service arrived in November 2019 and quickly raced to have well over 130 million subscribers. Netflix acknowledges this changing landscape in its shareholder letter:
“However, over the last three years, as traditional entertainment companies realized streaming is the future, many new streaming services have also launched.”
Netflix was a company that was remarkable at anticipating changes and pivoting. This time, the competition came in hot, and Netflix wasn’t prepared. The Covid-19 surge in subscribers (and the company’s record $1.9 billion free cash flow in fiscal 2020) might have given a false sense of success when deep scrutiny and thought were perhaps the demand of the hour.
With growth slowing and perhaps even shrinking, it makes sense to focus on the cash generation of the business. This quarter’s free cash flow was $802 million versus $692 million a year ago. That’s good. But on a trailing twelve-month basis, it was a tad below breakeven. Compare that to a year ago when it was $2.4 Billion, but that was also a time of moderated content spending. So perhaps there’s some light at the end of the tunnel. Netflix can generate gobs of cash, provided it doesn’t need to spend everything it has to bring and retain subscribers.
Netflix management highlighted password sharing as one area of attention, estimating that about 100 million households use Netflix but don’t pay for it. Now account sharing isn’t a new thing. It’s always been there, but in stiff competition for new subscribers, management believes that tapping existing non-paying users for money is a step potentially in the right direction.
Historically, Netflix has abhorred the thought of launching an advertising-supported tier. That philosophy appears to be changing, however, as the business tries to tackle developing economies with more price-sensitive consumers, with Reed Hastings noting the following in the post result conference call:
“Greg has done great work on the price spread. And one way to increase the price spread is advertising on low-end plans and to have lower prices with advertising. And those who have followed Netflix know that I’ve been against the complexity of advertising and a big fan of the simplicity of subscription.
But as much as I’m a fan of that, I’m a bigger fan of consumer choice. And allowing consumers who would like to have a lower price and are advertising-tolerant get what they want makes a lot of sense. So that’s something we’re looking at now. We’re trying to figure out over the next year or two. But think of us as quite open to offering even lower prices with advertising as a consumer choice”
I think this is a wise choice that might potentially open a new chapter of growth at the company.
Those seem like reasonable steps. It does worry me when Netflix ties its success to its ability to create great shows, noting things like this in its shareholder letter:
“Key to our success has been our ability to create amazing entertainment from all around the world, present it in highly personalized ways, and win more viewers than our competitors. These are Netflix’s core strengths and competitive advantages.”
I don’t think content production is a competitive advantage. Apple (NASDAQ: AAPL) TV Plus came on the scene in late 2019 and is already the first streamer to win the coveted Oscar award. What does Netflix have to say about that?
In my opinion, Netflix’s USP used to be its ability to be nimble and pivot in a timely way. They did that by moving from DVDs to streaming and then launching original content. But then they got carried away producing a mountain of average quality content! Along the way, they didn’t pursue their early efforts towards developing interactive content. The company is now pursuing gaming, but the real opportunity might be at the intersection of gaming and streaming content.
Don’t get me wrong. Netflix is a good company. It will play a role in our lives for a long time. Can Netflix find its earlier self and reinvent itself? Can it be great again? That’s the question at the top of my mind.