Netflix got Big but never got to Build a Moat or Margins

Blain’s Morning Porridge – 10^th Feb 2022: Netflix got Big but never got to Dig a Moat or Grow Margins

“Modern life is a muddle dictated by advanced technology, dated political systems and Stone Age impulses.”

This morning: Disney has just posted some great results on subscription growth, begging questions what it means for Netflix. Will the sector’s founder survive the current attritional Streaming Wars? And what’s it really worth?

The big story this morning is Disney’s solid numbers last night – the stock jumping 7% on good news! Mouse Co managed to beat predictions on its Disney+ Streaming subscriptions, and its parks and resorts business showed how quickly it’s coming out the pandemic. Great news all round – and a kick in the proverbials for Netflix, which you will recall dropped 20% at the start of this earnings season when its subscription numbers sucked. It shows Disney has the content viewers want, and they’ve got a solid profitable business backing that content.

Is it another reason to spank Netflix’s stock price? Perhaps.

Over the past few months I’ve never really got round to sorting out the TV in Dubai – I can’t find any decent news programmes so when I turn it on BBC World it’s there as background noise before I pick a streaming service. Perhaps the cleverest thing Netflix ever did was persuading TV manufacturers to put a Netflix button on controllers. Netflix is the invariably the one I click first. It’s easy and it establishes Netflix in your mind the moment you pick up the control.

Netflix was the brand that defined streaming. It’s also top of the worry list after its’ January stockdive – hinting at very difficult times ahead. The downturn in growth was predictable – the explosive growth in subscriptions during pandemic was bound to ease, and even reverse. The market is now trying to work out what post-Covid firms in busy, competitive spaces like “The Streaming Wars” are really worth.

Compare and contrast. 99 year-old Disney is something speshul. It’s not only got great content, but it works it remorselessly. I think there are now 313 Avengers Movies and at least 600 Stars Wars spin offs. (I can’t wait for a new series about the musical “journey” of the Mos Eisley Cantina Band..) Frozen 243 was watched by a quintillion happy little girls, while my great-grandkids will be playing with Woody and Buzz Lightyear merchandise.

Netflix should survive. It’s got the most appealing graphics, is easiest to navigate, and has the best presentation of the major streaming services. Prime’s page looks like a cheap laundry list, Disney feels like an add for their toy-shops, while trying to find a binge on Apple can be frustrating on its interminable pages. But, the question remains – what’s Netflix worth?

Netflix might look good and be the brand, but its future in an increasingly competitive Streaming Market will be content and subscription growth…. Can they grow subs to pay for programming? Is the management up to it? And are subs, content and vision the only factors?

Thus, I have doubts on Netflix.

Their problem is simple: Netflix innovated the sector, spawned competition where margins are thin and under increasing pressure, yet lacks any meaningful moat as the market continues to evolve. It is desperately racing to build margins and profit in an increasingly saturated market. In a highly competitive market and limited profits, a 30x earnings multiple is not sustainable.

Put simply: Netflix got mature before it got rich.. (The same lessons apply across the whole “get big first” tech cohort.) They are fighting for their future on multiple fronts – which is never a situation you’d pick.

Let’s start with Netflix’ first battlefront – Content:

They have some great programming. The Power of The Dog has scored 12 Oscar Nominations. Bridgerton and the Crown have broken the mould of conventional drama. Stranger Things and Narcos have become breakout hits. You can find excellent content like the quirky Robots Sex and Death, The Umbrella Academy, and many, many duds. (There is only so much Korean pap a grown man can be a**ed to watch… but how Netflix has disrupted and reinvented Korean TV is a saga worth reading: Netflix Needs New Subscribers. Its Korean Playbook is its Secret Weapon)

But they don’t have the franchise power of Disney to monetize everything from the Mouse, Thor and Skywalker. One day Netflix may stumble on a motherlode – but aside from Stranger Things what multiple season programmes have thrived? (Certainly not Witcher – no idea what season 2 was all about…)

They can create or commission their own content or license from others. That was how Netflix grew; licensing popular series like Friends and both versions of The Office, effectively renting old hits to their developing subscriber base. As the big content owners have opened their own services, Netflix’s access to legacy programming has largely shut. (I find myself watching a lot of BritBox classic comedies and series – which they don’t carry – although I still can’t find I Claudius or the original War and Peace.)

The critical success of The Power of The Dog with 12 Oscar nominations puts Netflix up there as a serious film player as the business evolves post pandemic – will it go back to Hollywood launches, or will Direct to Screening become the norm? The crowds flocked to the new Spiderman, Dune and the recent James Bond travesty – but I suspect the long-term is more home viewing. Netflix’s most successful streaming film was apparently the awful Red Notice!

This leads the second battlefront – Netflix’s cable war

Netflix was the classic disruptor. The typical US family apparently paid over $100 per month in cable fees. Now they have 4.4 streaming subscriptions costing less than $60.  Netflix is spending $30bln+ per annum on content to attract and retain these viewers. It’s wrecked the cable business, where Disney Channel, HBO, Sky, Warner et al had been making decent money from monetising content profitably. It’s forced them to join the down-cost streaming wars.

Which means Netflix is now in a long-term war of attrition with these content providers. Can it out content Disney? And the others?

As the new Amazon Lord of the Rings prequel demonstrates, it’s predicted $50 mm per episode highlights just how expensive content will become.. Giving the populace ever better bread and bigger circuses bankrupted Rome, and could well break streaming. Who will win the war of attrition, and what’s to play for? Younger audiences might abandon TV for shorter entertainment formats. At the moment audiences want bigger, better and more expensive. Netflix as to balance spending vs revenues – at some point will it have to say enough is enough?

The third battlefront for Netflix is subscriptions.

At the moment they are “probably” the leader in the streaming market – and that is a terrible position to be in in a hot market. They are the target. With a major cost-of-living shock on the back of inflation and energy prices coming, will households retain all their streaming services? Perversely that may be a positive for Netflix as the “obvious” choice to keep.

Streaming subscriptions are about human behaviour – years ago when HSBC acquired sub-prime lender Household we commissioned some research and discovered the very last thing a broke customer stopped paying isn’t the mortgage, but subscriptions to the sports channel! The assumption is most households won’t want more than three subscription channels in the home. Pick and choose from Disney, Netflix, Roku, Prime, HBO, Apple, Sky, and a host of others.

Today… Netflix is number 1 in a top 3 pick. Tomorrow?

Some analysts think the pandemic is just a blip. They believe Netflix can continue to grow its subs year on year and increase subscriptions above inflation. That’s a big ask in the UK where it apparently already has 80% of the market, and a major cost-of-living crisis is set to drain consumer discretionary spending. But, for the purposes of the argument, let’s assume Netflix continues to grow subscribers, and create exciting new content.. How will it pay for it?

Netflix was clever. It funded its growth years with cheap debt rather than raise equity – $17 bln at one point. Now it says it’s reached an equilibrium where it can cover costs from subs and pay down its bonds. Should they? Can they? Leverage helps returns and boosts the attractions of the stock.. but in a highly competitive market where subscriptions are potentially a loss-leader, then will be tempting to keep borrowing to stay at the top by subsiding content – or even to take out a competitor or three via acquisitions? Disney has very deep pockets. Netflix has very short arms.

It begs the question – will Netflix simply remain a highly indebted firms that’s forced to keep borrowing to stay one step ahead of it’s rivals… or…

What matters is how much they can make by improving margins. Raising subscription prices looks attractive, but they charge $2.50 in India vs $15 in the US. They can trade quality vs cost for these cheaper markets, but that leaves browsing viewers disappointed by the sham of some Asian drama with spacemen costumed with boiler suits and fishbowls on their heads..

Streaming is a fascinating market – but the current war is attritional, leaving very slim margins for all players. Something will change. Winners will emerge or it will evolve. Selling advertising space might be an option, but runs disenchantment risk? Netflix’ move into Gaming is… “interesting” and has “optionality” – which my analyst tells me means it might or might not become a valuable part of the Netflix business sometime into a future timeline.

So what’s my conclusion on Netflix? Great product. Massively overvalued stock. Likely to be acquired at the right price…

Five Things to Read This Morning

Torygraph – Meet the “Crocodile of Wall Street”: the rapper accused of $3.6 bln Bitcoin fraud

WSJ – Disney’s Earnings Show Rebound in Disney+, Parks Business

FT – Why Countries should restructure debts sooner rather than later

Bberg – The BOE’s £3 Billion Loss That Puts QE on Road To Fiscal Burden

BBerg – Junk Bonds Climb on Prospect of State Support: Evergrande Update

Out of time, back to day job…

Bill Blain

Strategist – Shard Capital