This article was originally published for Leads From Gurus members on July 26 and updated on September 20.
“It’s not the strongest species that survives, nor the smartest that survives. It’s the one that most adaptable to change.” -Charles Darwin
Netflix, Inc. (NASDAQ: NFLX) is currently in a difficult phase of its business with decelerating growth due to lower discretionary spending and the company is also facing the most aggressive competition since its inception with companies like The Walt Disney Company (DIS) and Amazon .com, Inc. (AMZN) establishing their presence in key markets such as the United States and India. Netflix’s approach has always been to keep its business model as simple as possible as part of its growth goals. But in a context of declining subscriber growth, the company is now forced to evolve and adapt, which risks complicating its business model. Nevertheless, these changes are necessary to ensure sustainable long-term earnings growth.
Many investors have been watching Netflix very closely over the past few months given lackluster subscriber additions and downgrades from Goldman Sachs (GS), UBS Group AG (UBS) and many other Wall Street analysts ahead of the release. second quarter results. Netflix, however, pleasantly surprised the market with earnings beating analysts’ expectations and in particular, reporting a subscriber loss of 970,000 in the second quarter, which was considerably lower than the 2,000,000 originally forecast.
In this article, I will explain how Netflix is turning a corner with its level of ad-supported content as well as the much-needed changes to its content policy.
What we know about the level of ad-supported content
Netflix initially hinted at an ad-based model in April this year and announced in July that it was set to partner with Microsoft Corporation (MSFT) in this venture aiming to launch in early 2023. According to several reports from renowned entertainment companies recently, Netflix has advanced the launch schedule for this ad-supported tier to November 1 to get ahead of Disney+ which plans to launch its ad-supported tier on November 8. december.
Based on management feedback, this ad-supported tier will launch in a few select markets where ad spend is already high. With the United States being the country that spends the most on digital advertising and the region where Netflix derives most of its revenue, Netflix will likely launch this level of content in the United States before focusing on other key markets. According to Variety, Netflix will launch the ad-supported tier in the United States, Canada, United Kingdom, France, and Germany.
Exhibit 1: Netflix Revenue Breakdown
Netflix isn’t the first to adopt this strategy as Hulu and HBO Max already offer ad-based plans that are more economical than their ad-free services. Disney+ is also set to join streaming platforms that offer ad-supported streaming.
The best example Netflix could use as a benchmark would be Hulu, with Netflix’s CEO even calling the model a hit in April 2022. With a subscriber count of around 40 million, Hulu generates almost $3 billion in advertising revenue per year. According to Insider Intelligence, this represents nearly 1.8% of total digital ad spend in the United States.
Figure 2: US digital advertising revenue share, by company
Having partnered with Microsoft, it will be important to see how the company approaches the situation as it is not part of its core business model. It is an advantage to be the largest streaming company in the world with a significant number of minutes viewed by subscribers on its platform. This massive subscriber base and engagement rate puts Netflix in a good position with potential advertisers, which in turn could create a reliable long-term revenue stream. I think the international segment is where Netflix stands to benefit the most from its ad-based plan. This segment was supposed to be the company’s next growth engine, but things didn’t go as planned due to low-priced offerings from competitors. With the exception of the APAC region, subscriber numbers have declined in all other regions over the past two quarters. I think a low-cost, ad-based offering will help Netflix kick-start growth in all of these regions.
Exhibit 3: Cost comparison between Netflix and Amazon Prime Video
It’s also a double-edged sword for Netflix, as bulk subscribers can switch to the low-cost ad-based plan, resulting in revenue cannibalization. But since full implementation of this level of content is expected to take effect over a few years, it allows company management to test it and arrive at a sustainable solution that doesn’t limit long-term growth potential. business term.
Wall Street analysts backtrack on NFLX
Netflix is no longer the darling of Wall Street. So far this year, Netflix hasn’t gotten much love from analysts due to continued declining subscriber numbers and inflationary concerns. The planned launch of the ad-supported content tier, however, sparked a flurry of analyst upgrades. It’s no surprise considering that Netflix could become one of the biggest players in the global advertising industry in the long run.
Oppenheimer analyst Jason Helfstein, who has a $325 price target for NFLX, recently upgraded Netflix to surpass and wrote in a note to clients:
Netflix is in a unique position to aggregate large audiences and control the timing of series launches for top advertisers.
Last week, Citigroup analyst Jason Bazinet raised his price target for Netflix from $275 to $305 and claimed that Netflix could gain around 65 million subscribers worldwide with its ad-supported tier. Speaking to Yahoo Finance, the analyst said:
Netflix does not have natural shareholders. It doesn’t add subs, so it’s not a growth stock. It doesn’t have a lot of cash, so it’s not a value stock, but if 65 million new customers sign up, we could be back in growth mode.
The praise Netflix receives from Wall Street analysts could be helpful in bolstering investor confidence in the company.
Netflix content strategy
Over the past few years, Netflix has spent huge amounts of money on content creation, which was in line with its aggressive growth strategy. In 2021, Netflix spent $17.7 billion on content, compared to $11.8 billion in 2020. In order to meet the needs of a wider audience, the company focused on expanding different varieties of titles in its library and the transformation of its service from second-run licensed content. to essentially original content. According to company filings, 60% of the net content assets on its balance sheet today are produced by Netflix. As noted in the Q2 shareholder letter, going forward, the company will not attempt to expand into new content categories, which will result in lower cash expenses versus amortization of the contents.
The company is looking to keep content costs at current levels, but is focusing on popular hits. This is highlighted with titles such as gray man which is his most expensive project costing $200 million, starring Ryan Gosling and Chris Evans. The company has identified the importance of titles such as stranger things which can “influence pop culture, create passion for Netflix, and create a differentiated and hard-to-replicate experience.” The company also wants to grow these big-budget projects by creating an additional revenue stream through spin-offs, which was explicitly mentioned by executives at gray man who confirmed that the film was created with extensions outside of Netflix in mind.
I think Netflix won’t reduce content creation costs, but will focus on creating titles that will get more bang for their buck. This is a good strategy to increase engagement and reduce subscriber churn in the short to medium term, but in the long term this strategy could cost the company potential subscribers because some audiences will run out of content to love on Netflix. That being said, Netflix may need to lose some types of subscribers today to kick-start subscriber growth over the long term.
The company does not plan to cut spending on non-English programming in key regions, which is an encouraging sign, although the move may limit near-term earnings growth.
Overall, Netflix is making significant changes to its content strategy, and investors will have to wait a few more quarters to see the impact of these changes on corporate earnings, subscriber churn and engagement levels. . As an investor, I’m leaning on the positive side because I believe these changes are necessary to ensure the long-term sustainability of Netflix’s earnings.
Netflix is in a consolidation phase. Although the company faces many hurdles today in the form of macroeconomic challenges and competition, I believe the long-term trends are still intact and subscriber growth will return to positive as the company rolls out the level of planned ad-supported content. It is not reasonable to expect the company to replicate the growth seen over the past decade given the intense competition in the industry. It will take patience to see better days with our investment in Netflix, but there is no need to panic despite all the negative chatter surrounding the company.