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3 Things Netflix Needs To Do Better

This article is more than 4 years old.

Netflix has transformed not just the entertainment business but also the way that the viewers watch television. It is one of the largest mass media companies in the world, with a market capitalization of $129.3 billion in November 2019. The streaming giant has a loyal subscriber base, which has allowed the firm to grow its revenues over time. In Q3 2019, Netflix had over 158 million paying streaming subscribers worldwide. The streaming service has built a business model of spending vast sums on content, using that content to attract new subscribers, and then using those new subscribers as its route to market value. By paying for its content, Netflix has built a more levered business model, where subscribers, both new and existing, have higher marginal benefits. This model provides the company with a stronger competitive edge, which is reflected in higher renewal rates and more pricing power, adding to the value per subscriber, both existing and new. This model also comes with a more significant downside because a slackening of the subscriber growth will leave Netflix much more rooted in the hole, with more negative cash flows.

Netflix expands globally

Netflix's Q3 earnings results have been "better than feared." While Netflix's global paid net additions hit 6.8 million, it was lower than the 7 million guidance. The U.S. net additions at 517,000 were less than 800,000 estimates, and the net international additions of 6.26 million were higher than 6.2 million guidance. The firm anticipated the losses in U.S. net addition, as large players are entering the streaming space. Netflix expansion globally is encouraging because compared to the expected single-digit growth rate in the U.S. subscribers, the international subscribers are expected to grow into the mid-30% by 2021. With over 100 million global customers (165 million, including the U.S.), overseas markets remain a focus for Netflix, especially as the U.S. matures. 

Netflix braces for Disney+ Impact

With content being king and Netflix, the clear leader in streaming with ~160 million subscribers worldwide, the goal of Disney is shaking this leadership position. To date, Netflix has enjoyed pricing power, but Disney is offering its streaming services at points that will likely push Netflix to trim prices, resulting in lower revenue per subscriber. Around 10%+ of Netflix's installed base could be disrupted by Disney+, which already has 10 million subscribers on its launch day last week. A $6.99 monthly price point (or $69.99 a year) and an estimated 60-90 million global subscribers by 2024 make Disney+ a formidable rival to Netflix. 

For Netflix, future revenue growth will come at a high cost. At $13/month, the average revenue per user (ARPU) of U.S. streaming subscribers was 44% above the $9/month ARPU for international streaming subscribers in Q2 2019. It will take three international subscribers additions to equal the revenue loss of two U.S. subscribers. Under an expected volume pressure from the shifting mix of net additions, a lower pricing strategy is necessary to slow down the declines in the U.S. subscribers. At $9-$16/month, Netflix will lose 5-10 million of its 60 million U.S. subscribers in 2020, unless it offers an economical service. Since the Netflix balance sheet cannot withstand more substantial cash losses, a new $7-8/month service is best. If Netflix considers adopting a lower pricing strategy, the expected earnings per share (EPS) growth rate will "stabilize" around 30%-40% range in the next two years. 

While Disney may have an advantage in the U.S. with about 85 million customers, Netflix might be the global winner with just over 300 million subscribers by 2024.

Future of Netflix

Going forward, Netflix will rely on its content entirely, instead of licensing programming. This approach has reduced its churn rate (the loss of existing customers), each year since 2015. In 2018, the annual renewal rate for a Netflix subscription was about 93%. For the firm, growth has come at a price with an estimated $15 billion in cash content costs and $19 billion in streaming commitments to gain over 100 million international subscribers. These investments will impact the margins. Netflix may burn about $3 billion of cash in 2020. Netflix currently holds $13.68 billion in liabilities with Debt to Equity (D/E) ratio of 224.0, signifying the company may have difficulties to generate enough cash to satisfy its financial obligations. Intense competition may force Netflix to ramp up spending to fuel subscriber growth, which may further delay profitability. Netflix's overall growth will be lesser in the future, compared with the past five years. 

The principal value driver for Netflix is content costs. If Netflix allows content costs to grow at high rates relative to revenue growth, then the company's equity value becomes negative, which means the company goes bankrupt. For Netflix to be profitable, it has to show discipline in controlling content costs. Hence, cost management will be a crucial factor in the medium term. The future of Netflix is less a bet on the business being able to deliver subscribers and revenue growth in the future and more on the future path of content costs at the company.

 

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