Is there any connection between last week's profit warning from S4 Capital (SFOR) and news that Netflix (US:NFLX) was hastening moves to establish a lower-cost, ad-supported subscription tier? Well, beyond an existing contractual relationship, you might argue that it shows two businesses struggling to optimise commercial models in industries that have been drastically altered by digital transformation.
Investors in Martin Sorrell’s new-age advertising outfit were spooked by news that rising staff costs at S4’s content division had outstripped sales and profit growth, leading to reduced profit guidance for 2022 and a freeze on hiring. It may be too much to expect greater working capital discipline from the company given the acquisition spree undertaken since it started trading in 2018. Yet it does raise concerns as to whether the rush to build scale has been pursued at the expense of margins.
The agency’s three-year business plan (2022-24) is targeting a like-for-like doubling in revenue and the restoration of cash margins to previous levels. The rate stood at 18 per cent for 2021, representing a three percentage point decline on the prior year, although that was largely the result of acquisition costs.
The rise in personnel costs through 2021 was in line with revenue growth and there was little sign that they were an issue at the first-quarter update at the end of May. Bosses were keener to highlight two further ‘whoppers’ in the early part of 2022, presumably that’s adspeak for ‘big-league clients’ and not a reference to any of the reasons given for the twice-delayed publication of its prelims earlier this year. Those two additions made a total of eight against a target of 20, as the agency strives for critical mass.
Delays to the publication of the results were unexpected and were partly down to problems linked to revenue and cost of sales recognition, a possible by-product of the agency’s breakneck expansion. S4 Capital has ambitious plans and is scaling-up rapidly.
That’s not surprising as the agency seeks to exploit the projected growth of digital advertising. Nonetheless, companies can grow too quickly and this is sometimes evident in the way that sales outpace operational capacity through a lack of scalable processes. No one has suggested that this is the case with S4 Capital, although the latest revelation about the content division would have done little to settle the nerves of investors, regardless of Sir Martin’s pedigree in the industry.
Netflix is another business blessed by a huge addressable market, albeit a rather unpredictable one. The streaming service has been around a little longer than S4 Capital and while it, too, is an industry disruptor, you get the impression that its optimal subscription model remains elusive.
That last statement might seem baffling given that the service can boast around 221mn subscribers across the globe. But the massive boost to numbers resulting from the stay-at-home provisions during the lockdowns may have masked some of the inherent flaws in its model.
Expectations have certainly come down to earth since the pandemic. Although the company’s share price was on the rise following release of its recent trading update, it was because it had shed only 970,000 subscribers in the three months to 30 June against an earlier estimate of 2mn – progress of sorts, I guess.
The market may have placed greater store in the company’s plan to accelerate the rollout of a cheaper subscription tier or the fact that action is being taken to clamp down on account sharing. The latter move is a no-brainer, but it remains to be seen whether the former offering will appeal to viewers based on price alone. At £10.99 a month, the standard subscription rate isn’t exactly prohibitive. Unfortunately, households are trimming discretionary budgets in the face of runaway inflation – and it only takes about two minutes to cancel your subscription.
It’s also now an increasingly crowded marketplace with around half-a-dozen genuine rivals, most notably Amazon Prime and Disney Plus. With those two companies, it could be argued that their streaming services are complementary to their core businesses – respectively ecommerce and content creation – rather than central to it. Netflix doesn't have that luxury.
Another reason why subscription numbers are under pressure is that Netflix generally offers complete seasons, rather than weekly programme releases. The way in which season 4 of its blockbuster Stranger Things series was released in two parts – the second just after the half-year mark – might provide a pointer to how the streaming service will keep punters interested on an ongoing basis, although this shift underlines why disrupting an established industry is no guarantee of commercial success in itself.
