In 1665, Cambridge University closed as a precaution against the plague. Isaac Newton retreated to his home at Woolsthorpe in Lincolnshire and spent the next two years – in what we might characterise as lockdown – working out calculus, optics and developing his universal law of gravitation. For most of us coping with a 21st century plague that has blighted our world, binge-watching boxsets on Netflix (US:NFLX) has seemed ample diversion.
Few companies can have enjoyed such a boost from the enforced incarceration of lockdown. Sofas never had so much use. Shares in Netflix soared as users flocked to the platform in the first half of the year, but the growth is slowing, and the competition is getting a lot tougher. So can Netflix retain its status as the king of the streamers?
Undoubtedly, Netflix secured a huge boost from the global lockdowns in the first half of 2020. Paid net subscriber additions – a key metric used by the company and investors alike – jumped to 26m in the first half of 2020 from 12m during the same period a year before. To put this extreme outperformance in context, Netflix added 28m through the whole of 2019. But as we, like well-behaved prisoners, are allowed out more and more, growth is slowing. The company forecasts 2.5m paid net adds for the third quarter versus 6.8m in the prior year and expects the figure will be down year on year in the second half since the strong first-half performance “pulled forward some demand from the second half of the year”. Management argues that most of the increase in the first half was a pull forward of demand, rather than demand creation. But Netflix is getting good at “tamping down expectations”, in the words of Reed Hastings, the co-founder, chairman and now co-chief executive.
We will explore the structural and societal shifts taking place that may mean this is more than a pull-forward of demand later, but there is a chance subscriber growth will continue at a pace that exceeds these forecasts when third quarter earnings are released on 20 October. Bernstein analysts wrote in July following the second quarter earnings call: “We believe management continues to be conservative in their guidance (why would they not be? Nobody knows what to expect in the throes of this pandemic. There is no precedent). Reasons to believe there is upside to the Q3 guide include: a) July net paid adds, to date, have resumed growth (after a flattish June); and b) churn remains at all-time lows, including in the EU where much of the population has returned to work.”
Cash flow has always been a little lumpy since content spending comes in fits and starts. In similar fashion to the net subscriber adds, while the last couple of quarters have been good, it won’t necessarily look as strong in the coming quarters. Netflix was free cash flow positive in the second quarter to the tune of +$899m versus a $594m outflow in the second quarter last year. This was the second straight free cash flow positive quarter, but the company thinks it will turn negative again in 2021. The pause in production has pushed a lot of spend out into the back end of 2020 and 2021. But the improving free cash flow profile is also down to an important long-term shift towards production of Netflix originals, which requires more cash upfront versus licensed content. Margins are also improving, with the company expecting to see a 16 per cent operating margin for the year and 19 per cent for 2021.
First it took out Blockbuster, then for several years you couldn’t mention Netflix without referring to it as a cord cutter taking on cable and satellite and making life tough for terrestrial networks like ITV (ITV). Now Netflix is increasingly turning its attention to the silver screen.
The sad fact is cinemas are on life support, and this is likely to be a significant driver for Netflix in the coming years having already cut the cord of terrestrial TV. The pandemic will have a lasting drag on cinema visits as more people fear being in close proximity to others and stay at home. The value you get from a Netflix subscription compares very favourably with going to the flicks – it costs about the same for a month's subscription as for one visit to the movies. And you don’t need to mingle with anyone else. Working from home also helps Netflix.
Increasingly, content creation from big studios that drove the cinema industry is shifting to Netflix – for example director Martin Scorsese’s The Irishman. Indeed, two Oscars from 24 nominations at the 2020 Academy Awards underlines how Netflix has fundamentally disrupted the film industry as much as it did TV, and there is further it can travel along this road.
We should also consider emerging markets and the spread of faster, higher quality broadband as another important driver. JPMorgan, for instance, forecasts that long-term growth will hit 300m subscribers by 2024 due to the rapid acceleration in global broadband penetration, particularly in Latin America and Asia-Pacific – combined subscribers in those two regions are still less than in the US and Canada. 5G will also have important implications for streaming content on-the-go.
Netflix has been the undisputed leader in the streaming wars, but there are a couple of terriers nipping at its heels. It’s a highly competitive space, with the likes of HBO, Amazon (US:AMZN) Prime Video and Apple (US:AAPL) in the mix. In particular, the arrival of Disney+ has shaken things up over the past year. Barely 11 months since it launched, Mickey Mouse and pals have accumulated more than 60m global subscribers, versus the 193m Netflix has built up over years. Disney (US:DIS), of course, has an extraordinary back catalogue of films and TV, yet the rapid growth of Disney+ must be a concern. Or is it? “Instead of worrying about all these competitors, we continue to stick to our strategy of trying to improve our service and content every quarter faster than our peers,” the company says.
And it goes beyond streaming services – Netflix now counts TikTok as a competitor. It’s all about chasing eyes, and whatever distracts consumers is a rival.
Consumers are meeting a sudden explosion of choice in not only streaming services that did not exist a year ago, but also social media platforms and other entertainment channels. This is relatively new and uncharted waters for Netflix. Instead of winner takes all, Netflix will need to be content to be primus inter pares, first among equals. The good news is that consumers are showing greater capacity to load up with multiple subscriptions. So-called ‘subscription fatigue’ is a barrier, but for now this remains a bigger hurdle to newcomers than it is to Netflix – being the first among equals ensures yours is not the first to be cut. Most people who subscribe to video on demand services have a Netflix account (see table).
Content is king
So, it’s losing Friends and The Office – big deal. Netflix does content like no one else, even if its universe of content has shrunk by 5,000 titles in 10 years. The Street remains positive on the stock, citing the content mix as a key factor in the ongoing investment thesis.
Analysts at Goldman Sachs believe that Netﬂix’s “massive content investments, global distribution ecosystem and improving competitive position will further drive ﬁnancial results signiﬁcantly above consensus expectations”. Cannacord is similarly enthusiastic: “Netflix’s content library investment allowed the company to evolve from a platform to watch re-runs to a quality source of original content, and now a destination for some of the biggest movie premieres, which makes the service an essential part of any consumer entertainment bundle.”
But content is a double-edged sword. To date Netflix has needed to keep spending and investing billions of dollars every year just to keep up. Netflix doesn’t show live sport, nor ads – it's a simple old-fashioned TV and movie business, and this requires the budget to spend on production to keep the crowds entertained.
Netflix continues to outspend its rivals, which helps it maintain an edge. Spending on content will exceed $13bn this year alone. But it has borrowed heavily to achieve this and continues to tap debt markets – it raised $1bn in April and holds over $15bn in long-term debt. Moreover, there is a concern that the pandemic has slowed the pace of new content production, which could make it tougher for Netflix to maintain momentum. However, the latest quarterly results indicated low churn that spoke to the possibility of Netflix being able to maintain growth without the commensurate investment in content – ie that net adds is not a direct function of content spend. Citi noted: “On one hand, a resumption of content spend could cause net adds to reaccelerate. On the other hand, without heavy spending, sub growth is muted.” Margin growth points to a more mature business – I would anticipate that Netflix is now on a trajectory where it needs to spend incrementally less to attract and retain subscribers, albeit next year could see a slowdown in net adds just as content spending ramps, as Netflix itself has guided.
The real growth for Netflix will come outside the US – it is now available in 190 countries – and ramping local production of content is a key part of this process. It carries significant execution risks – but then every time you start the cameras rolling on a new production you are taking a risk. For every diamond like Tiger King there are probably a dozen flops.
Local language content, such as Spain’s La Casa de Papel, Dark in Germany and Sacred Games in India have been successful and one feels that this is the type of content that can generate the kind of growth in LatAm and Apac that is required. And it has Meghan and Harry now, too.